Wealth Building Lessons

Many of us carry debt on our credit cards, car loans, student loans, mortgages, etc. But once you have your emergency funds saved up, the inevitable question arises. Do you invest your savings or pay off your debt?

You’d definitely want to invest for your future, but also don’t want all your hard earned money to go to lenders in the form of interest payments and finance charges. So you need to calculate whether you’re better off using your money to pay down your debt vs keeping the debt and using the money to invest instead.

You need to figure out whether you can earn a higher after-tax return on your investments than the after-tax interest rate expense on your debt? If so, you should invest. Otherwise, you’re better off paying your down your debt. Lets look at an example.

Lets assume you have a 30 year $250,000 mortgage with a 7% interest rate. Lets consider that you’re in the 25% tax bracket. Due to the tax-deduction on mortgage interest, your after-tax annual percentage is approximately 7% minus your tax rate, or 5.25%. ( 7% - 7%x0.25 = 5.25%)

NOTE: The taxation is slightly more complicated than mentioned here, but this is almost good enough for our example.

This means that if you can earn an after-tax return on investment higher than 5.25% on your investments, you’re better off investing. Any investments in a retirement account are tax-free or tax-deferred so investing a broad index based mutual fund with low fees will usually result in a long term 8%+ return. (like the Vangard S&P 500 Index Fund VFINX which has an expense of only 0.18%)

If however, you’re carrying a balance on your credit cards at 18%, almost no low-risk investment will generate that sort of returns. You’re much better off paying down your credit card balances, even if you have to use your emergency funds. Except for rent/mortgage payments, there aren’t any emergency expenses that you can’t put on your credit card. So if you have enough savings to cover a few months rent, you are usually better off using the remaining emergency funds to pay off your credit card debt.

You must exercise the self-discipline to re-establish your emergency fund before you go out and rack up your credit card bills again. I know this sounds extremely obvious, but I’ve seen 40 year old paralegals working for bankruptcy attorneys fail to do simple things like this. You carry too much debt, invest your money in illiquid investments (or investments that lose money) and are then forced to file bankruptcy when emergencies occur.

Do you remember the day-traders in 1999 and 2000? Some of them borrowed money out of their homes and lost it in the stock market. The last thing you want to do is over-leverage yourself and invest in high-risk investments. If you lose your investments, you end up losing your house. How many of you think your spouses will stick around after you bet the farm and lose it?

And if you think you will have a need for liquidity in the near future (like a child going to college) then you’re better off putting your money in an interest bearing savings account regardless of whether its better or worse than paying off debt. There are even checking accounts which pay out almost as much interest as regular savings accounts.

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