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A common question I get asked as a financial advisor is about paying down debt versus investing when the opportunity arises.
Usually someone has some extra money from a bonus, tax refund, or some other windfall.
However, as we moved through the Covid-19 pandemic, questions often arose after someone received severance pay.
Regardless of the source of the money, you need to carefully consider the decision to pay off the debt or invest.
Many financial experts recommend paying off debt first.
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There are good arguments for this, for both financial and non-financial reasons. Financially, the debt is paid off and you no longer pay interest – and that is good stuff.
There are also psychological and emotional benefits. Mortgage burning parties used to be big business. These holidays were meant to celebrate becoming true owners of a property, free from the liability and risk of the property being encumbered.
Homeowners did not have to worry about what would happen if they lost their jobs or if some other economic disaster struck. They might sleep a little easier at night knowing that, at the very least, âI have a roof over my headâ.
Now, on the other hand, a school of thought suggests that if your after-tax return on investment is greater than the after-tax cost of your debt, then you should invest the money.
A simple example works like this: You owe debt that carries a 4% interest rate. We will assume that the interest is deductible.
Now assume a return on investment of 8%. If you’re in a 22% marginal tax bracket, that makes the effective cost of your debt 3.12%, compared to an after-tax return on investment of 6.24%.
In this scenario, it makes sense to invest the funds and pay the minimum on your debt.
Obviously, there is a risk of comparing a certain cost of debt to an uncertain return on your investment, so be very careful if you take this approach.
Now, there is a third option in the debt-versus-investment debate, and it can be summed up with a quote from Yogi Berra, a brilliant baseball player and manager. Yogi was also famous for his comically wise words, known as âyogi-ismsâ. One of his most famous jokes recalls this third option: “When you come to a fork in the road, take it.”
The decision to pay down debt or invest doesn’t have to be a choice decision. Why not try to do both?
Often times, this option allows someone to have their cake and eat it too.
You save money on interest charges, but you also get the money invested. This is a particularly good option when there is not enough funds to completely pay off the debt.
Let’s be honest, for many people, investing is more âfunâ than saving or reducing interest charges, no matter what the calculations suggest. There is also the added benefit of making a habit of investing rather than procrastinating.
Whichever option you choose, it’s important to take the time to think about it, make a plan, and then execute it.
In other words, follow the road map that makes sense for you because, as Yogi said: âIf you don’t know where you are going, you will end up somewhere else.