What Kind of Debt Should You Pay Off First?
Many of us view debt as a financial liability to eliminate as quickly as possible, but not all debt is created equal. Some debt is good to have and offers long-term benefits, while bad debt can have a negative effect on your financial well-being. A sound debt management strategy helps to keep the two in balance so your financial life can remain stable and healthy.
Good debt keeps you moving forward financially – like a home mortgage. While it may take you 20-30 years to repay this money, you are building up equity in your home in the meantime. Not many people can afford to buy a house with cash, so a mortgage allows you to reach your goal of owning a home faster. Hopefully, during the time of your home ownership, your house also will appreciate in value, so by the time you pay off your mortgage, you will be ahead financially. Then you may be able to sell your house for more than you paid for it — and your net worth increases. Plus, you will have enjoyed many years of creating and living in a home that has brought happiness to you and your family.
Bad debt, on the other hand, does not leave you financially ahead in the end. Unlike a 30-year mortgage that allows you to build up your net worth over time, bad debt often costs you more in the long run. Credit card debt that accumulates and incurs higher interest rates is one example of bad debt. Charging $5,000 on your credit card for an expensive vacation you can’t afford, and then paying it off at an 18% APR (annual percentage rate) for five years can be a major financial drain on your resources. Those interest payments can be costly. Getting a car loan at a high rate of interest to buy a used car could turn out to be bad debt, too – especially if the life of the car is limited because of its age and condition.
So when you have extra cash on hand and want to reduce your overall debt load, it is often better to pay down your bad debt first because it is costing you more to carry than good debt. For example, it makes more financial sense to pay off your credit card rather than making extra payments to lower the principal amount owed on your mortgage.
What Investments Should You Consider?
So what if investing your money is a better use of your resources right now than paying off debt? Choosing the right investments is a personal decision that depends a lot on your risk tolerance, which measures how comfortable you are with assuming more risk to possibly earn a higher rate of return on your money. If you are a more conservative investor, you may want to consider safer investments vehicles which carry less risk and typically earn less money than other kinds of investments. A diversified portfolio of investments that contains a variety of assets can often be the key to helping you reach your financial goals. Consulting with a financial professional may help you better understand your current needs and future goals and what investments are right for you at this point in your life.
What Factors Should You Consider to Decide Whether to Pay Off Debt or Invest?
Our calculator is designed to help you decide whether to pay off debt or invest your money based on financial and tax criteria. However, making a sound financial decision regarding what to do with your money may involve several other key factors:
- Budget – Often the best first step toward getting your debt under control is to review and adjust your budget. Are there expenses you can live without? Tightening your financial belt may enable you to set aside extra money on a regular basis to pay down your debt. Paying off debt requires thoughtful planning and financial discipline. Evaluating your budget may enable you to do both: pay off debt and invest.
- Income – Your annual income dictates your taxes, which in turn affects your after-tax cost of borrowing (being in debt) and your after-tax return on investing. Given your income level, tax bracket and deductions, knowing your financial situation after crunching the numbers through our calculator will help you determine if you are better off paying down your debt or investing. A dramatic increase or decrease in your annual income in the foreseeable future, however, may affect your taxes and in turn how you go about making the right decision regarding your debt and investing.
- Financial goals – Your financial goals also may influence your decision whether to pay off debt or invest. Will you need a new car in the coming year? If so, you may want to put that extra money into a short-term investment so you have enough for a down payment when the time comes (and adjust your budget in the meantime to continue paying down your debt). Consider how your financial goals may tip your decision one way or the other.
- Stage of life – Your stage in life can (and should) have a major impact on your financial decisions. As a single person, you may want to work on paying off your credit card debt now so you don’t have it as a financial burden once you’re married. If you are just starting a family, maybe you want to invest in a 529 college savings plan for your child. However, if you are approaching retirement age, you may be interested in putting your extra cash into an Individual Retirement Account (IRA). Think about your current life stage and its influence on your monetary decisions.
Using This Calculator
Assets and liabilities are two sides of the financial teeter-totter. Ideally, you want your assets to outweigh your debts. So when you have an influx of extra cash, is it better to use that money to pay down your debt or invest it so it grows over time? Our calculator can help you answer that question. Financial theory recommends that if your after-tax return on investments is greater than your after-tax cost of debt, then you should invest that money. If the opposite is true, you’re financially better off paying down your debt.
About Your Inputs
Is it better for you to pay off debt or make an investment with the money you have? Our calculator asks you to make a few simple financial assumptions about your debt and investment options before pointing you in a preferred direction.
Rates & Assumptions
Our calculator will suggest a course of action on whether to pay off debt or invest your money once you answer a short series of questions about your interest and taxes:
- Interest rate on debt – What current rate of interest are you paying on your debt? This amount can vary widely, depending on the type of debt it is. For instance, credit card interest rates can be much higher than those for mortgage loans. Enter a figure between 0% and 40%.
- Is the interest deductible? – Certain types of interest you pay on your debts are tax-deductible. According to the IRS, interest payments made on home loans (mortgage as well as home equity loans), student loans and business loans are all tax-deductible. In addition, interest paid on money borrowed to buy investment property is tax-deductible. Personal interest — which includes interest on credit cards, car loans, late/unpaid utility bills and late payment or underpayment of federal, state and local income taxes — is not tax-deductible. Answer yes or no here.
- Before-tax return on investment – What rate of return are you earning on your investment? Keep in mind that either a positive (meaning your asset gains value and makes money) or negative (meaning your asset declines in value and loses money) rate of return might apply.
- Is the investment taxable? – The IRS provides examples of taxable interest — which include interest on bank accounts (checking/savings), money market accounts, certificates of deposit (CDs), corporate bonds and deposited insurance dividends. Interest income from Treasury bills, notes and bonds is subject to federal income tax but exempt from all state and local income taxes. The taxable rate assumed is based on your current marginal tax bracket and is subject to change. Refer to IRS Topic No. 409 Capital Gains and Losses for tax information on capital gains/losses after selling assets like a home, stocks, mutual funds and bonds. Answer yes or no here.
- Marginal tax bracket – If you answered yes to either question about whether your interest is tax-deductible or taxable, you will need to include your marginal tax bracket. Enter a percentage between 0% and 75% for the amount of federal taxes that you pay.
About Your Results
This calculator compares your after-tax cost of debt with your after-tax return on investment to determine which path is more financially advantageous. Taking into account any tax implications, this Pay Off Debt or Invest? Calculator gives you the percentage your debt might cost versus the percentage your investment could make. Depending on which is higher, the calculator will suggest what to do with your surplus funds. In addition, a bar graph provides a visual comparison of your cost of debt and return on investment percentages in different colors.