Should You Pay Debt or Save Your Money?
Interest Rates and Tax Effects Dictate Whether You Should Pay Debt or Save Money
Here are some simple rules to follow when deciding whether to pay down debt or save and invest your money. Start by looking at the percentage you pay on your debt and compare it to the return you could expect on your investment. If your debt is a higher rate, then you would typically pay it down first. However, if the debt is a lower rate or very close to the same rate, there are other things that you should look at. Here are our recommendations on whether you should pay debt or save:
If paying down your mortgage:
Generally, it is better to invest your money than to pay down your mortgage. Here are the reasons why:
- Mortgage interest is tax deductible. Part of the money you pay for your mortgage can be deducted. This, in effect, lowers the interest rate that you are actually paying. For example, an 8% mortgage after taxes, assuming a tax rate of 40%, is really the equivalent of 4.8%. Mortgage interest is deductible against your income, investments are taxed separately, and do not reduce your income taxes.
- You can't easily get back money that you use to pay down your mortgage. Unless you take out a second mortgage or home equity loan, the extra money you pay on your mortgage is not accessible if you get into a bind and need money.
- You should be able to earn more money by investing in the stock market. Average stock market returns are in the 8-14% range, depending on the risk level. Average mortgage rates are much lower, especially when you factor in the tax advantages of mortgages.
- By investing the money instead of paying down the debt, you will have a safety fund that you can fall back on in case you lose your job or need money for an emergency.
- If you are near the end of your mortgage and are not paying much interest, it makes more sense to pay down your debt faster. It will free up monthly income that you can then use to invest each month. It will also lower your monthly expenses and give you a mental boost that can help you focus more on saving and investing.
If paying down non-mortgage debt:
Generally, we recommend paying off your debt first, especially if it's a much higher interest rate than you could earn investing your money. Assume an 8-14% range for your investments. Since non-mortgage debt is not tax deductible, this is an easier calculation than paying down your mortgage. If the interest rate on your debt is close to the interest you could earn investing your money, we recommend that you pay down some of your debt and invest at the same time. This will help you build a nest egg for emergencies, and at the same time free up room on your credit cards in case of an emergency.
With that said, make sure that you continue to put the maximum amount of savings into your 401K if you are getting an employee match. Always take advantage of any employer match, it is free money! If you aren't getting an employee match, we still recommend adding money to your Roth IRA each year, even if you're still in debt. Retirement accounts are generally protected from creditors and it is never too early (or too late if you haven't started yet) to start investing in them.
See Also: Other Retirement Articles