Is it better to invest or pay off debt? Unfortunately, there's no simple answer. Part of this decision involves comparing the cost of the debt to what you expect to receive as a return. Another factor involves examining your risk tolerance and your overall financial situation. Both components must be considered to make the right decision for you.
Do the math
The initial decision to invest or reduce debt is based on calculations. You should compare your after-tax cost of borrowing against your after-tax return on investing to determine which gives you the best return.
For example, let's look at the decision to pay off a mortgage early versus investing. Consider a mortgage at a fixed 4% interest rate. You receive a tax deduction for the mortgage interest, so if you're in the 35% tax bracket, your after-tax cost of borrowing for your mortgage is 2.6%.
In contrast, examine your after-tax rate of return on an investment. Unless you plan to invest in a tax-sheltered account or a tax-free municipal bond, taxes will reduce the actual return on an investment. For example, if you expect to earn 10% on a short-term investment but you're in the 35% tax bracket, your return after taxes would be 6.5%.
You also must consider the effect of inflation on your investment. If inflation is expected to grow at 2% a year, you must adjust your return by that amount. The 6.5% after-tax return on the investment above would be reduced to a 4.5% real return after accounting for inflation. While this return is lower, it would still make sense to make this investment versus paying down the mortgage.
For many investments, there's no guaranteed rate of return, and you may not know how long you'll hold the investment, what dividends you'll receive, or what rate of tax to apply to the investment. It's still valuable to calculate a ballpark estimate to consider which alternative is most likely to give you the best outcome. There are a number of online calculators that can help you make these estimates so you can compare and determine which choice makes more mathematical sense.
Listen to your gut
Even if your calculations indicate it may be more financially beneficial to invest, it's important to consider your comfort with debt. If being indebted keeps you awake at night, paying off your obligations is the right decision for you.
You may have goals to pay off student loans before you buy a house or start a family, or maybe you don't want to carry a mortgage into retirement. Paying off existing debt may be an important milestone to you.
While being debt-free is a fabulous goal, be careful that this goal doesn't override investing for your future. If you have a 30-year mortgage and want to wait until it's paid off before investing, you could be close to retirement before you start.
Carrying low-interest mortgage or student loan debt while starting long-term retirement investments is a wise decision since it's likely your retirement investments will have a better return than what the debt is costing you. Remember, you never have a second chance to reap the benefits of long-term compounding interest, so make it a priority to invest early.
Examine your overall financial situation
It's also important to look at your total financial situation as part of your decision. If you've got student loan debt, an auto loan, a mortgage, and a high-interest credit card balance, it may be wise to pay off some debt before investing. Examine your debt-to-income ratio by dividing your monthly debt by your monthly income. Financial counselors recommend that you have no more than 20% non-mortgage debt.
Carrying too much debt can also negatively affect your credit score. Lenders look at this information when extending credit, so if you want to purchase a home or apply for other types of credit, it's important to keep your debt-to-income ratio low.
There are many considerations when deciding whether to pay off debt or invest extra funds you have. Sometimes it's best to do a combination of both by attacking the highest interest debt while simultaneously investing at least as much to take advantage of any matching contributions offered by your employer. As your debt decreases, put more money toward your investments. Set a personal deadline for paying off debt obligations so you can focus fully on investing for your future.