How to figure out the best use for your extra money.
Hhmmm. Does it make more financial sense to invest my spare money or to use it to pay down debt? It can be a perplexing question, but I’m going to help you with the answer in this and in next week’s show.
Should You Invest or Pay Down Debt?
Whether you should invest your extra money or use it to pay down debt is a hotly debated topic in personal finance. No matter what type of debt you may have--a mortgage, car loan, student loan, credit card, or all of the above--it’s likely that you want to pay it off as soon as possible. But you also want to save for the future so you’ll have financial security. With only so much money to go around, how do you decide where to send it?
Determine the Highest Return on Your Money
When you boil down the investing-versus-debt-reduction issue, the real question is which option will bring you the highest return on your money. In other words, what’s more profitable: investing with the expectation that your money will grow or saving the interest expense that you have to pay on your debt? When you pay off debt early, you’re actually earning a guaranteed interest rate that you’d otherwise have to pay.
Taxes Affect Your Returns
The tricky part about this issue is that income taxes come into play. Taxes can make a huge difference because they make some investments less profitable but they also make some debts less costly. In this show I’m going to focus on how tax breaks affect tax-deductible debt. Next week, in part two of this topic, I’ll discuss how taxes affect your return on investments. After you hear both shows, you’ll be able to make a wise decision about what to do with a financial windfall or discretionary money that you have left over each month.
How Taxes Affect Debt
Debt comes in two basic categories when it comes to taxes: tax-deductible and non tax-deductible. Tax-deductible debt includes mortgages, home-equity lines of credit (which are also known as HELOCs), student loans, and money borrowed for business purposes, up to certain limits. Every other type of debt, such as a credit card, auto loan, or payday loan, falls under the non tax-deductible category.
So why distinguish the two types and what’s the big deal about tax deductions? The answer is that tax deductions save you money. When you can claim a deduction, your taxable income is reduced by the amount of the deduction, which lowers the amount of tax you have to pay. A debt actually costs you less when you claim an allowable deduction for it. That means a tax break lowers the effective interest rate that you have to pay. I’ll give you a couple of examples in just a moment.
To correctly evaluate whether you should pay down a debt early instead of choosing to invest the money, you need know the after-tax interest rate for both options. First, you have to know your income tax rate and then you have to do some simple math. I’ll show you how easy it is. You’ll find a link in the show notes at the bottom of this page.
How the Mortgage Interest Deduction Lowers Your Taxes
Follow this scenario about a girl named Amy who has $150 left over in her budget each month after she invests in her retirement plan at work and pays all her monthly expenses. She’s wondering whether to invest the $150 or to send the money to her mortgage as an extra principal payment each month.
Amy has an interest-only mortgage of $200,000 with a 5% annual interest rate. That means she pays a total of $10,000 per year in interest ($200,000 x 0.05 = $10,000). But since she claims the home mortgage interest deduction, her mortgage actually costs her less than $10,000 a year. I did a recent show about the home mortgage interest deduction, so if you missed episode number 141, be sure to refer to it for more details. The deduction allows Amy to subtract $10,000 from her taxable earnings each year. And as you know, less taxable income means less tax to pay.
The amount Amy will save in taxes by claiming the home mortgage interest deduction depends on her income tax rate. Her income puts her in the 25% tax bracket. Twenty-five percent of her $10,000 tax deduction equals $2,500. So, reducing her taxable income by $10,000 allows her to save $2,500 in taxes. And if she doesn’t owe any taxes, she’ll receive that money as a tax refund.
When the tax deduction is taken into account, you can see that the real annual cost of the interest on Amy’s mortgage isn’t $10,000--it’s reduced by her tax savings of $2,500. So the interest she pays on her mortgage effectively costs her just $7,500 per year. If you divide $7,500 by her mortgage balance of $200,000, you get her after-tax annual interest rate, which is just 3.75%--not too bad! Oh, and remember Amy. She'll be back in part two.
How the Student Loan Interest Deduction Lowers Your Taxes
The same calculation works for student loans, except that there are some limitations with the student loan interest deduction to keep in mind. To be eligible to take the deduction in 2009, you must have adjusted gross income that’s less than $70,000 for single filers or less than $150,000 if you’re married and file a joint return. There’s also a limitation on how much you can deduct; you can only deduct up to $2,500 each year for the interest you pay on a student loan that’s for you, your spouse, or your dependents.
Let’s say Henry is paying off a student loan. He’s married, files a joint tax return, and will report taxable income of $100,000 in 2009—that’s below the allowable income limit, so he qualifies to take the student loan interest deduction. He has a student loan balance of $80,000 with a 4% interest rate, which costs him $3,000 in interest for the year. As I mentioned, the maximum amount you can claim in 2009 is $2,500, so the remaining $500 that Henry paid isn’t tax-deductible.
Henry’s income puts him in the 28% tax bracket. When his income is reduced by the allowable $2,500 deduction, he saves $700 in taxes. That’s $2,500 times 0.28. Now the interest cost of his student loan drops by $700--from $3,000 a year to $2,300. If you divide $2,300 by his student loan balance of $80,000, it gives him an after-tax interest rate of 2.87% on the loan in 2009.
Now you know how tax deductions lower the interest rate you have to pay for tax-deductible debt. Join me on the next show where we’ll continue discussing how to figure out if you should pay off debt or invest your extra money. In part two, I’ll talk about non tax-deductible debts, such as credit cards, and I’ll discuss how to evaluate your after-tax return on investments. Then you can compare the money you’d save by paying off your debt to the money you’d earn by investing.
If you want to improve your grammar and have fun at the same time, you’ll love
The Grammar Devotional by Mignon Fogarty. It’s a small, beautiful book that’s perfect for toting around and reading every day whenever you have a few minutes. Find it in bookstores or on Amazon.com.
Stop by and visit the Money Girl Facebook page. When you become a fan you’ll receive current updates from me. Feel free to make comments or leave short questions there too. Of course, you can always e-mail me at firstname.lastname@example.org or leave a voicemail message at 206-339-9069. If you forget my contact information, just go to the Money Girl section at quickanddirtytips.com
I’m glad you’re listening. Chi-Ching, that's all for now, courtesy of Money Girl, your guide to a richer life.
U.S. Federal Individual Income Tax Rates History, 1913-2009
Image courtesy of Shutterstock