The best way to put your spare cash to use depends on the rates you’re paying on debt, the length of time you plan to be invested, and how much stress you are willing to have in your financial life. Sometimes paying off debt is the best “investment,” while other times it makes more sense to put money in the stock market. The key is to determine which situation you are in.
A Real-Life Feeling…. Certainty vs. Uncertainty
Paying off debt feels like you have a guaranteed win. When you pay off a debt you know you are eliminating that interest cost – there is no guess work, market volatility, or unexpected loss that will take place as long as you keep paying the debt. On the contrary, investing your extra cash is more like gambling. You have a chance to win; however, it does not matter how long you leave your money invested; you will never know for sure whether you will win or lose.
If having peace of mind is important to you, then paying off debt is usually the best option for emotional (not just numerical) returns.
Think about paying off debt as providing a “negative” rate of return (i.e. the rate charged on the debt) and investing as providing a “positive” rate of return (i.e. the rate of return on your investment).
For example, if you pay off a debt with an interest rate of 18% per year, it is equivalent to producing a guaranteed return on your investment of 18%. Consistently beating 18% no matter what the stock market does is going to be close to impossible to do.
Pay off your higher interest debts before your lower interest debts because it’s an attractive investable option for you.
Capital gains taxes – Taxing Investments Will Have a Negative Impact On After-Tax Profits Earned on the Stock Market
You will not receive 100% of your profits earned from an investment in stocks. The reason are due to capital gains taxes. The actual return on a 7% return earned in the stock market could be closer to 6% after tax.
You will receive no capital gain tax implications, thus your payoff from paying down your debts will be immediate and your savings will be at 100%.
Risk Is The Unknown
The markets can go up, down, sideways and ‘crazy’; however the greatest historical trend over the long term is upward.
There is no risk associated with your ‘debt payoff value.’ You will not wake up one morning with your ‘debt payoff value’ down 20%.
When stability is more important than getting an upside return, then paying off your debt will typically produce a better return.
Credit Cards —> If a person has $20K in credit card debt at a rate of approx 18% and has $5K available in the form of cash to ‘invest’… it is probably not the best investment as they would need to earn over 18% in the stock market to generate a higher return than paying off their credit card.
Moderate Student Loans —> If the above example had a student loan at approximately 6% and extended out over a longer timeframe, the mathematical analysis would become more complicated.
If the goal is to pay off the debt within 1-2 years, then paying down the debt may be the best approach.
If the timeline for repayment extends over many years, then using some of the repayment funds to invest may yield greater long-term benefits than simply paying off the mortgage quickly.
Time is the most important factor in your decision on which way to pay off debt.
Low Interest Mortgage
If you have a mortgage that is approximately 4% with a long-term repayment period, investing will typically provide better total returns in the day-to-day situations that you face rather than aggressively paying it off.
In the long term (greater than 10-15+ years), the stock market has historically provided returns that exceed the interest you pay on your mortgage.
Shift That Way of Thinking When Considering Which Direction to Take
There are two very important questions that you need to ask yourself:
How fast do I want to be debt-free?
How okay am I with experiencing variations in value due to market forces?
For those who want to be debt-free in a short period of time, they should consider paying off their mortgage.
For those that want to build long-term wealth, they should consider investing their repayment funds.
Deciding to either invest or pay off debt is fundamentally a risk analysis, financial priorities/values, and very personal decision.
What is good for somebody may not be good for someone else with regards to how efficiently or how much stress is created.
For expensive debt – hurry up and get rid of it.
If the debt is cheap and a long-term solution – think about investing that money in something you want.
Getting rid of your debt can be priceless when you want to reduce your stress, have fewer bills and have clear thinking.
