It may still be a good idea to invest rather than pay off your debt more quickly. As long as you can reasonably expect to earn a better return from your investments than the interest you pay on your debt, it's generally a good idea to invest.
Pay off debt or invest?
In a nutshell, if you have a realistic probability of earning more from your investments than you would pay in interest, it's generally better to invest with any extra money you may have. For an obvious example, if you have the choice between paying down credit card debt at 19.9% interest or investing in a stock mutual fund that has historically produced 10% annualized returns, it's a better idea to use any surplus money you have toward your credit card debt.
On the other hand, some situations are not so obvious. For instance, if you're paying 6.5% interest on your student loans, and can earn 6% returns from tax-free municipal bond investments, it seems like paying the debt would be the better option. However, when you factor in the tax deduction for student loan interest, this isn't the case.
With that in mind, here's a calculator that can analyze your interest rates, investment strategy, and tax situation in order to answer the question, "Should I pay off debt or invest?"
4 things to keep in mind when using this calculator
1. Be realistic: Don't assume your investments are going to earn high returns on a consistent basis. If you notice, the calculator doesn't even allow expected returns greater than 12%. It's best to use the historical average for the type of investment you're considering -- hover over the question mark on the calculator to find yours -- or even use a few percent less to be conservative.
2. Is your interest tax deductible?: If you're paying a mortgage, you can deduct the interest you pay if you itemize deductions on your tax return. Student loan interest is deductible whether you itemize or not. There are a few other, but less common, forms of deductible interest, such as interest on business debts.
3. Is your interest (investment return) taxable?: If you invest in an IRA or 401(k), your investment returns are not taxable on an annual basis. In a standard brokerage account, your dividends and interest payments are taxable, as are profits on investments after you sell them. For example, if you're investing in corporate bonds, the interest payments you receive will be taxable if held in a standard brokerage account.
4. Pay your high-interest debts first: When using this calculator, use the highest interest rate you're paying, not simply an average of all of the interest rates on your debts. For example, if you have a mortgage at 5%, credit cards at 18%, and student loans at 6%, use the credit card interest rate, since that's the debt to pay first.
As an example, let's say that you have $100,000 in mortgage debt at 5% interest, which is tax-deductible if you itemize on your tax return. Let's say that you're in the 25% tax bracket. You have an extra $500 per month after making all of your standard debt payments, and are wondering whether you should invest that money in large-cap U.S. stocks in a non-taxable account, or use it to pay down your mortgage faster. In the interest of being conservative, we'll assume your stock investments return 9% per year, less than the actual historic average of 9.8%.
According to the calculator, putting that $500 per month toward your mortgage would result in a one-year interest savings of $104 after accounting for the tax savings of mortgage interest. On the other hand, if you invest that money instead, it should result in a one-year return of $254. Therefore, you'd be better off investing instead of paying down your mortgage.
Now, it's worth keeping in mind that a 9% return from your stock investments isn't guaranteed each year -- far from it, actually. Your investments may lose money in any given year. However, the point is that you're determining whether investing or paying off debt gives you the best opportunity for financial gain.
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