Money Monday: Decisions, Decisions: Is It Better to Invest Or Pay Down Debt?
Guest post by Christine Benz, director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-By-Step Guide to Managing Your Finances (Wiley, 2010).
Enter to win a signed copy of 30-Minute Money Solutions by Christine Benz today! It’s easy – just post a comment following today’s Money Monday post and you’re entered to win!
“Andie, hon. Listen, it's after 7:00. Don't waste good lip gloss.” - Pretty in Pink, 1986
Bet you didn’t think that a Molly Ringwald movie from the ‘80s could teach you something about money and investing, did you? Think again. Because if you understand that your Chanel Glossimer is best reserved for those times when you need to look your loveliest, you probably also understand that your hard-earned cash should be deployed toward those opportunities that give you the biggest return for your buck at that particular point in time. And once you master that concept, you’re well on your way to financial fitness.
If you’re just starting out, it’s a good bet that you’re trying to juggle multiple financial priorities all at once. You may be paying off student loans or credit card debt, or perhaps you have a mortgage or car loan; you may also be able to contribute to a company retirement plan at work. With only so much money to go around, where to begin?
Anchor Your Financial Decisions in The Numbers
Rather than just winging this financial decision — and that’s easy to do — take a minute to anchor your decision-making in the numbers. Start by writing down your opportunity set — any debts outstanding, such as student loans, mortgages, or credit card debt, as well as any investment opportunities you have available to you, such as a 401(k) plan or Roth IRA.
Next, think about the rate of return you’re likely to earn on your money. And yes, paying down debt counts as earning a return on your cash.
For example, if you have a balance on your credit card and the interest rate is 16%, paying off that debt will earn you a 16% rate of return. You’d be hard-pressed to beat that percentage with any investment in the market; stocks have historically returned in the neighborhood of 8%-10%, and safer investments like bonds have returned about half that much. So paying down that balance should be your highest money priority.
Where to invest isn’t always that black and white, though. Mortgage debt and student loans typically carry much lower interest rates, and you may be able to deduct that interest on your taxes, making your real interest rate even lower. In that situation, you shouldn’t feel any urgency to pay off your debts because you could probably earn a better return on your money by getting started with an investment plan.
Prioritize Your Financial Goals: Paying Debt and Investing
There are no one-size-fits-all answers for setting your financial priorities. Personality also plays a role. If you're more conservative, you may take great comfort in being as debt-free as you can be, whereas if you're more adventurous when it comes to your finances, you might not mind carrying a little debt if it enables you to invest in the market.
However, the following sequence can help you deploy your money sensibly.
First priority (tie): Debt with a high interest rate relative to what your investments are apt to earn, where interest is not deductible. I’m mainly talking about credit card debt here, but other types of high-interest (greater than 8%) consumer debt also falls into this category.
First priority (tie): Company retirement-plan contributions that your employer is matching. Not contributing enough to earn an employer matching contribution is the equivalent of turning away a 100% return. You don’t need me to tell you that’s not a very smart investment decision!
Second priority: IRA or company retirement-plan contributions, but only if you are directing your contributions toward higher-returning long-term investments like stocks. Not only do IRAs, 401(k)s, 403(b)s, and 457 plans enjoy tax-favored status, but you can also realistically assume that your stock investments will offer fairly high long-term returns. Don’t worry about stocks’ risks — you won’t be tapping this money for many years, so you’ll have time to ride out the rough patches.
Third priority: Debt with high interest rates (8% to 10%) where interest is tax-deductible — or debt with reasonable interest rates (5% to 6%), where interest is not tax-deductible.
Fourth priority: Debt with reasonable interest rates (5% to 6%) and tax-deductible interest. Most home mortgages and student loans fall into this category.
Fifth priority: Investments whose expected rates of return are in line with, or lower than, interest on debt and that enjoy no tax benefits — for example, saving in a plain-old savings account or even a money market fund.
Your Money Monday task for this week: Review the interest rates on your debts to figure out how to prioritize each debt (see first, third, fourth priorities listed above). From there, you’ll be able to prioritize your investing and savings plan (see first, second, fifth priorities listed above)
Enter to win a signed copy of 30-Minute Money Solutions by Christine Benz today! It’s easy – just post a comment following today’s Money Monday post and you’re entered to win! You can enter every Monday in April. Come back to GalsGuide.com for Money Monday.
Leslie Banks
Reader Comments (6)
Great tips! I struggle with this all the time, as both my fiance and I have student debt and neglected savings accounts. My employer RRSP contributions will kick in soon, and THEN we're buying a house in a couple months. Oh, and trying to pay for our wedding next year. I don't even know where to throw my money.
I'm going to use this to get my priorities straight. :)
Hi Christine, Thanks for these great posts!
How do you feel about idea of builing a small emergency fund before paying down debt? With jobs being cut all the time and emergenices like a car break down, it seems that some cash in the bank is important right now vs. being totally debt free.
I agree with you in that money is not a black and white thing. It very much depends on your values, personality and your habits.
I cut up my credit cards in February and it's been a big adjustment. Now that I'm starting to get used to it, I'm trying to plan my next steps.
Thanks for your thoughts!
Nicole
Thanks for your feedback! Christine's column next week will talk about building up an emergency fund vs. paying down debt. Christine and I are also filming a video next week, so if there are questions you want me to ask her, post a comment!
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