Find out whether you should pay off a mortgage or invest your extra cash to improve your personal finances.
A podcast listener named Tracy asks:
“I’ve accumulated savings that aren’t earning anything in the bank. How do I know if I should use the cash to pay off my mortgage or invest?”
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I’m a big proponent of getting out of debt as soon as possible. However, before you pay down a debt ahead of schedule, it’s important to weigh the pros and cons. The surprising truth is that getting rid of some types of debt could actually be a bad idea. Let me explain.
When you pay off a debt you need to make sure that it’s the best way to leverage your cash. Let’s say you have a credit card that charges 18% interest. Paying it off is just like getting an 18% guaranteed return on your money after taxes. That’s an excellent use of your financial resources because you’d be hard-pressed to find a similar investment in the real world!
On the other hand, using cash to pay down a debt that only cost 2% after taxes is a poor use of your financial resources because you could leverage the money for a higher return. For instance, right now you could make fairly conservative investments that earn 5% after taxes.
Of course, there’s no guarantee that an investment will always pay off, but the idea is to give careful consideration to how your cash can benefit you the most.
Here are 3 situations when it’s not smart to get out of debt:
Your debt has a low interest rate. As I mentioned, when the interest on a debt is lower than what you could reasonably earn from an investment, you’re better off keeping the debt. Instead, invest your excess cash to accumulate wealth for the future.
Your debt is tax-deductible. A few types of debt come with built-in tax deductions, which make them less expensive on an after-tax basis. The 3 most common types are mortgages, home equity loans, and student loans. Some or all of the interest paid can be used to reduce your taxes. If your after-tax interest rate is less than what you’d earn on an investment, opt to invest your money and keep the debt instead.
Your debt is secured by an asset that will appreciate. When you finance something that’s likely to increase in value over time—like real estate or a business—it helps you build wealth. But financing things that don’t appreciate—like vacations, clothes, and electronics—is a losing proposition because they have no future value.
Mortgages are one of the most inexpensive debts because the interest rate is relatively low to begin with and you may qualify to deduct the interest portion of the payment. That’s a one-two savings punch that’s hard to beat.
Related Content: Who Can Deduct Mortgage Interest
The only exception is if you already have a sufficient nest egg for retirement. In that case, paying down a mortgage is a great idea. But if you don’t have plenty of retirement savings, consider that you’re likely to earn more by investing than by paying down an inexpensive debt.
Other Articles and Resources You Might Like:
Investment Tips: How and Where to Invest (the Easy Way)
Use a Top Mortgage Refinance Company to Save
25+ Best Personal Finance Tools
How to Invest a Windfall
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