It’s a long-standing issue and the subject of much debate: If you have extra money, which should you do first – pay off debt or invest?
In fact, you have three options. For example:
You can use extra money to pay off debt. Whether you should pay off a mortgage, a car loan, credit card balances or a family member’s student loan before investing depends on the interest rate of the debt. The “magic number” will vary by individual but, broadly speaking, if the interest rate is higher than 10%, you should pay off the debt. Why? Because you are unlikely to get that high a return on a stock market investment over the long term.
Use any extra money to invest. If, however, the interest rate on your debt is low, you may want to consider investing before you pay off your debt.
Generally speaking, if the interest rate is lower than 5% (as it could be on your mortgage, for example) you may be better served by investing your extra money in stocks or stock mutual funds.
What about bonds? In fact, bonds may not be the ideal investment, as their yield is currently low.
So with an interest rate on your mortgage of, say, 4%, purchasing a bond or bond fund that yields approximately 2% wouldn’t make sense.
Note: For US taxes, it looks like whatever and whenever congress decides what happens to tax rates, the sacrosanct mortgage interest deduction will remain untouched for the foreseeable future, so do not forget to factor it in your calculation.
Use some of the extra money to pay off debt, and some to in- vest. You could also use a portion of your extra money to pay down your debt, and invest the remainder in stocks. Perhaps start at 50/50, then adjust based on stockmarket performance. For example, in a rising market, you might put 75% of your extra money toward stocks and use 25% to pay off debt.
For many, this option’s a winwin. But just to be sure, ask your advisor.
Note: This material has been prepared for informational purposes only, and is not intended to provide financial advice for your particular situation.
Yann Kostic, MBA and Tom Zachystal, CFP, are Presidents of their respective Assets Management firms, both US-Registered Investment Advisors (RIA). Tom is the San Francisco Financial Planners’ Association President. Tom and Yann cater to US ex- pats in Mexico and worldwide. Comments, questions or to request his newsletter, “News you can use” contact him at firstname.lastname@example.org, in the US at (321) 574- 1521 or in Mexico, (376) 106-1613.