Your Debt Interest Rate vs. Your Investment Rate of Return
Often the most discussed way to decide whether to pay off debt or to fund investments is to determine whether you could earn a higher after-tax rate of return from your investments than the after-tax interest rate you pay on the debt. For example, say you have a credit card balance on which you pay nondeductible interest of 15%. By getting rid of those interest payments, you're effectively getting a 15% return on your money. That means your money would generally need to earn an after tax return greater than 15% to make investing a smarter choice than paying off debt. That's a pretty tough challenge even for aggressive investors.
Keep in mind, the higher the rate of return, often there is greater risk on investments. If you make investments rather than pay off debt and your investments incur losses in the near-term, you may still have debts to pay, but you won't have had the benefit of any gains. By contrast, the return that comes from eliminating high-interest rate debt is a sure thing. In summary, the higher the interest rate on your debt the wiser it is the pay off debt instead of investing.
A 401k Match May Boost Your Return on Investments
If your employer matches a percentage of your 401k account contributions, that can make the debt vs. investing decision more complicated. Let's say your company matches 50% of your contributions up to 6% of your salary. That means that you're earning a 50% return on that portion of your retirement investment account. If surpassing a 15% return from paying off debt is challenging, getting a 50% return on your money simply through making contributions to our 401k is even more difficult. In this scenario, you know in advance what your return from the match will be; very few investments can offer the same degree of certainty. That's why many financial experts argue that saving at least enough to get any employer match for your contributions may make more sense than any other investment option.
Don't forget the tax deductibility of contributions to a 401k plan. By contributing pretax dollars to your plan account, you're deferring anywhere from 10% to 39.6% in Federal income taxes.
If you itemize deductions, the interest you pay on a mortgage is generally deductible on your federal tax return. Let's say you're paying 5% on your mortgage and 15% on your credit card debt and your employer matches 50% of your retirement account contributions. You might consider directing some of your available resources to paying off more on the credit card debt and enough towards your retirement account in order to get the full company match, and continuing to pay the normal tax-deductible interest mortgage payment.
There's another good reason to explore ways to address both goals. Time is on your side when saving for retirement. If you say to yourself, "I'll delay saving for retirement until I completely pay off my debt," you run the risk that you'll never get to that point, because good intentions about paying off your debt may falter at some point. Putting off saving also reduces the number of years you have to save for retirement and weakens the power that compound interest has to grow your retirement savings.
Bear in mind that even if you decide to focus on retirement savings, you should make sure that you're able to make at least the monthly minimum payments owed on your debt. Failure to make those minimum payments can result in penalties and increased interest rates which will only make your debt situation worse.
Other Factors to Consider
When determining whether to invest for retirement or pay off debt you should consider the following factors.
- Do you have the ability to refinance or consolidate larger interest rate debt to a lower interest rate.
- If you decide to down debt first, set up your payments to be made automatically from your checking account, so there won't be any temptation to reduce or delay payments.
- Do you have an established emergency fund? If you pay off your debt, you run the risk of building it back up in an emergency if you don't have an appropriate cushion to protect you.
Whichever decision you decide it important to build a budget and plan to accomplish your goal and then critical to stick to that goal.