Get both sides of this hotly debated financial issue.
If you’re fortunate enough to receive a cash windfall or to have some extra money left-over each month, you’ve probably wondered about whether you should invest it or use it to pay down your debt. Today’s episode is part two of this topic, so be sure to read or listen to part one to fully understand it. Since this issue is a hotly debated topic I’ve also included common pros and cons that are argued on both sides of this issue. That made this episode a little longer than usual, but if you stay with me, I think the information will help you make wise financial decisions.
Taxes Affect Your Annual Returns
Before you can make a decision about the best way to use your spare cash, it’s important to analyze your options and see which one is the most profitable. The key to figuring that out is getting down to what a debt costs you after taxes or what an investment will earn for you after taxes. Taking taxes into consideration is so important because it allows you to make an “apples to apples” comparison using the real numbers.
In the prior show I discussed how to calculate the after-tax interest rate you pay for tax-deductible debt. Remember that there are three personal debts that are tax-deductible: mortgages, home equity lines of credit, and student loans. Most people who have those types of loans are eligible to claim a tax deduction and reduce their taxes. That can substantially lower the effective annual interest rate that you have to pay for a debt. It’s kind of like getting a mail-in rebate on something you buy--you pay full price now, but the rebate lowers the real price you eventually pay once the rebate is received.
The Cost of Non Tax-Deductible Debt
Non tax-deductible debt includes every other type of debt you can think of, such as a payday loan, a note for a vehicle, or a balance on a credit or retail charge card. There’s no tax savings for a non tax-deductible debt, such as a credit card, so it’s easy to analyze what it costs you after-taxes, because the interest rate doesn’t change. For example, a 14% annual interest rate on a credit card still costs you 14% after taxes.
How Taxes Affect Different Types of Investments
Now, let’s switch gears and talk about how taxes affect your investment returns. Just about all investment earnings are taxable except for those made within a qualified retirement account. Retirement accounts such as a traditional workplace 401(k) or an IRA are non-taxable in the sense that you don’t pay tax in the year that you make money in them. But don’t be fooled into thinking that you never have to pay tax on your retirement account earnings. Your taxes are simply deferred until you withdraw the money in the future.
Roth retirement accounts, however, throw a fly in the ointment because they have tax rules that are flip-flopped from traditional accounts. With a Roth, you pay income taxes on the money in the year you invest it, instead of when you withdraw it in the future. And your earnings in a Roth account aren’t just tax-deferred, they grow absolutely tax-free!
How to Figure Out How Much An Investment is Worth
Remember Amy from part one of this topic? She cut back her spending and has $150 left over each month. We figured that the after-tax interest rate on her mortgage is 3.75%, which means that using her spare cash to pay off her mortgage early would give her a guaranteed 3.75% annual return. The question is whether she can find a better way to use the money that would yield a higher after-tax return. There are so many different ways she could invest, but let’s say she found a bond fund with a ten-year historical performance that exceeds an annual return of 6%, including fund fees. She needs to figure out what the fund’s return would be after paying taxes on the earnings.
In part one I told you that her income tax rate is 25%. That means 25% of her taxable income goes to the government and 75% goes to her. To figure out Amy’s after-tax return on a taxable investment, you simply multiply the return by 75%--the portion that she gets to keep. Seventy-five percent of 6% equals 4.5% (0.06 x 0.75 = 0.045). So the bond fund should give Amy a 4.5% annual return after taxes. Since that’s higher than her after-tax mortgage rate of 3.75%, investing $150 each month is a better use for her spare money than sending it to her mortgage. The investment would yield Amy 4.5% after-taxes whereas paying down her mortgage would only save her 3.75%.
If Amy decides to invest $150 each month in a Roth IRA, instead of in a taxable investment, she’d have an even higher return. She wouldn’t have to pay any taxes on the earnings, so she’d earn the full 6%. Choosing to invest is the more profitable option for Amy. But remember that taking the investment route is speculative and involves a level of risk.
Should You Invest or Pay Off Your Credit Card Debt?
What about the option of investing versus paying off credit card debt? Let’s say Greg has a $10,000 credit card balance with a 19% annual interest rate. He earned a $2,000 bonus at work and is wondering whether he should swing for the fences and invest the money or if he should do something less exciting with it and pay down his credit card balance. As I mentioned, there isn’t a tax deduction for credit cards, so his after-tax credit card rate remains 19%. But in order to compare it “apples to apples” to a potential investment, we need to figure out the investment’s after-tax return.
If Greg is in the 15% tax bracket he’d have to earn a minimum of 22.3% to get an after-tax return of 19%. I won’t bore you with the math for that on the podcast, but you’ll find the calculation in the show notes.
[Here’s how to figure the minimum investment return Greg would have to get to exceed his credit card interest rate: Divide the card’s rate by one minus his income tax rate. That’s 0.19 / (1 – 0.15) = 0.19 / 0.85 = 0.223 = 22.3%].
Finding a solid investment that will earn 22.3% before taxes seems pretty unlikely. So, in this case Greg should opt to pay down his high-interest credit card debt because it gives him a guaranteed 19% return, which is terrific! I hope this demonstrates why using your money to pay down high-interest debt, instead of investing it, is almost always the best option.
Pros and Cons of Paying Off Debt
In the first example about Amy, her extra money was better spent making a prudent investment because the return was expected to be higher than the savings she’d reap from paying down her low-interest debt. But there are some who argue that you should always opt to pay down debt--including low-interest debt--even when the math clearly indicates that investing is the more profitable choice. They believe you should get rid of all debt come hell or high water! Here are their most common arguments:
Psychologically, you have more peace of mind with little or no debt, even if you’re missing out on higher potential returns.
That investment returns aren’t guaranteed, but paying off debt does give you a guaranteed return, even if it’s a low one.
That paying off debt is safer because you may not manage an investment wisely.
On the other side of the coin are those who argue that you should use your excess cash to make investments to build wealth instead of paying off low-interest debt. They view low-interest debt as a tool that can be used wisely to help meet your financial goals. Here are their common points of view:
That paying off debt early could leave you cash-poor in the event of an emergency.
That once you sink money into paying off a mortgage, it could be very difficult to cash out your home equity if you need it. If the value of your home decreases or if your credit score declines, you may not qualify for a refinance.
That you could be missing out on huge potential investment returns that might outpace the interest rate on your debt. In other words, why pay off a 5% loan when you could be earning 10% on that money?
That a low fixed-rate mortgage or loan payment is a great hedge against potential inflation. If interest rates go up, your future payments will effectively cost less than they do now.
The quick and dirty tip is to invest your extra money whenever the after-tax earnings are expected to be higher than the after-tax interest rate on your debt. However, the best solution for you should depend on your tolerance for risk and your long-term financial goals. If you still feel conflicted about the issue, one solution is to do both. You could send half your spare cash to pay down low-interest debt and the other half to build wealth in a higher-yielding investment. I started a discussion about pre-paying debt on the Money Girl Facebook page--I hope you’ll weigh in with your ideas about this topic!
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I’m glad you’re listening. Chi-Ching, that's all for now, courtesy of Money Girl, your guide to a richer life.
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