Money in your pocket? Consider your options
You have money left over after paying current expenses. Should you invest it with an eye to income, or should you use it to pay off interest-bearing debt?
The conventional wisdom is that, if the interest on the debt is greater than the income from the investment, pay the debt. However, the basic math of comparing current return on your investments to current interest may be simplistic. You need to consider other factors.
Emergencies
Do you have cash for an emergency? If you were to lose your job or suffer other unexpected circumstances that either interrupt your income or create unexpected expenses, do you have cash to cover expenses?
Many experts recommend having an emergency fund that could tide you over for six to 12 months. Living paycheck to paycheck in today’s economy is risky, so consider whether you need an emergency fund before you pay off debt.
Kinds of debt
What kind of debt is being paid off? Some persons attempt to pay off their home mortgage at an accelerated pace by sending in extra money with their payments. It may feel good to own your home free and clear, but it may not make economic sense to pay off the mortgage quickly, especially if you itemize deductions on your tax return and can deduct the mortgage interest.
The interest rate on your home mortgage likely is much less than on your credit cards or some of your other debt. If you have extra cash to apply to debt, it makes more sense to pay off debts bearing the highest interest rates first. Also, the tax savings from the mortgage interest deduction that you take partly offsets the interest you pay on the mortgage.
Before deciding which way to go, factor in the tax savings, calculate the net loss from the mortgage interest and then compare that amount to the income you expect to gain if you invest the extra funds.
On its face, it makes sense to pay off high-interest credit cards rather than save your money in accounts that bear a lower rate of interest. For example, if you are paying 15 percent interest on your credit card balance and earning 2 percent interest on your savings account, you’re not actually saving anything – you’re losing 13 percent each year! Many financial experts routinely recommend getting rid of those high-interest credit card debts ASAP.
Retirement savings
What about your retirement savings? Contributions to a 401(k) grow tax-free until you begin withdrawals upon retirement. If you participate in a 401(k) in which the employer matches your contribution, not participating is like giving away free money.
Contributions to a Roth IRA compound tax-free, and the increase is not taxed when you begin withdrawing for retirement. Calculate what you would gain and lose over time by stashing money in retirement versus paying off debt – then you’re in a better position to make a wise choice.
Important purchases
Do you need to make a purchase that’s important to you – perhaps more important than the net gain calculated by comparing the income of your investments versus the outgo of interest?
You may have additions to the family and need to purchase a bigger home – which means you need to save money for a down payment. Perhaps you want to send your child to a private school. Simple accounting doesn’t take into consideration circumstances such as these that don’t easily translate into dollars.
Investment opportunities
Finally, there’s the question of whether you should have some money in reserve available to invest when the right opportunity comes along. Of course, no one knows if and when this will happen, but money used to pay off debt will not be available for investing if such opportunities arise.
Conventional wisdom is that steady and regular investing pays off over time. The past decade has been a historical anomaly.
According to The Wall Street Journal, in nearly two centuries of recorded stock market activity, stocks have never performed as dismally as they have during the last decade. Since the end of 1999, stocks traded on the New York Stock Exchange lost an average of 0.5 percent per year.
However, the average annual return from 1926 to 1999 was 11 percent. So, also consider the possibility that the market could return to better performance when deciding whether to save or pay down debt.
