all about How To : Should You Pay Off Debt Before Investing?

Should You Pay Off Debt Before Investing? One of the most common financial dilemmas is whether to use spare cash to pay off debt or to invest. It’s important to accomplish both, but with only so much money to go around, how do you know which to focus on first? If you’re not sure about the next move to make, it’s easy to feel stuck and never make progress with your personal finances.

In this post, I'll cover the main pros and cons of paying off debt before investing. Plus, you'll learn a simple method to prioritize your precious resources so you accomplish key financial goals and build wealth as quickly as possible.

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First Understand the Big Picture of Your Personal Finances

Too often we get bogged down by a specific financial decision or dilemma without considering the big picture. To make the best decisions, it’s wise to step back and take a holistic view of your entire financial life.

I created a simple, three-pronged approach called the PIP plan, which stands for Prepare, Invest, and Pay Off. Use it as a touchstone when considering how to allocate your money wisely.

1. Prepare for the unexpected.

Life is full of surprises and many of them drain your bank account! So before spending a dime on debt or investments, ask yourself if you’re really prepared for the unexpected.

In an instant, you could lose your job, see your business income dry up, get a serious illness, lose a spouse, or experience a natural disaster. It’s not fun to think about these types of devastating situations, but they happen.

While no amount of money can reverse a tragedy, having a financial safety net can make it so much easier to cope. What you need depends on factors such as your living expenses, debt payments, income, and whether you have dependents.

At a minimum, strive to maintain an emergency fund equal to three to six months’ worth of your living expenses. For instance, if you spend $3,000 a month on essentials (such as housing, utilities, food, and debt payments), make a goal to keep at least three times that amount, or $9,000, in an FDIC-insured bank savings account.

If accumulating that much money seems out of reach, don’t worry. Just get started with a small goal, such as saving $500, then $1,000, until you have at least one month’s worth of security on hand.

Having even a small cash reserve is better than nothing because it can keep you from going into debt in the first place if you hit a rough financial patch (and who hasn’t?). In Should You Invest Emergency Money or Keep Cash, I cover more about how to calculate how much reserve you need and the best places to keep it.

Another key way to prepare for the unexpected and stay out of debt is to have the right kinds of insurance. Being underinsured or uninsured means that a disaster, theft, or accident could wipe out everything you’ve worked so hard to earn and jeopardize your entire financial future.

For starters, if you drive (even if you don’t own a car) you could hurt someone and get sued for expensive injuries and medical payments. And having just the minimum amount of liability oftentimes isn’t nearly enough. For instance, in Florida you’re only required to purchase $10,000 in auto insurance liability. If you were found guilty for injuries totaling $100,000, you’d be on the hook for the balance of $90,000.

Then there’s homeowners and renter’s coverage. If you have a mortgage, lenders require home insurance—but most renters go uninsured, which is a big mistake. Renter’s insurance is a bargain for the protections your get, costing less than $200 per year on average. Just like a homeowner’s policy, renter’s insurance covers some amount of your personal belongings, liability, and living expenses if you’re forced to move out after a disaster.

The more income and assets you have, the more coverage you need to stay safe. Consider adding an inexpensive umbrella liability policy for additional protection above and beyond what you get on your auto and home or renters insurance.

And no matter what does or doesn’t happen to the Affordable Care Act, everyone should have health insurance to protect your finances. All it takes is one visit to the emergency room or a short stay in a hospital to rack up a massive medical bill that could turn your financial world upside down.

All it takes is one visit to the emergency room or a short stay in a hospital to rack up a massive medical bill that could turn your financial world upside down.

The last insurance I’ll mention is life insurance. It’s a must for anyone with family who would be hurt financially if you died. You can protect loved ones with inexpensive term coverage that may not cost more than $200 a year for a $500,000 benefit, if you’re in relatively good health.

You can get free quotes for any of these types of insurance using sites like insuranceQuotes.com or netQuote.com. The key to getting the best deal is to shop and compare quotes from multiple insurers.

The bottom line is that if you don’t have an emergency fund and don’t have insurance that’s critical for your and your family’s safety, you’re not ready to pay off debt ahead of schedule or to invest.

The only exception would be to pay off any dangerous debt you may have, such as overdue child support, tax liens, and accounts in collections. These can wreak havoc on your financial life, so they need to be addressed as quickly as possible.

2. Invest for the future.

Once you’ve prepared for unexpected events that could be around the corner, it’s time to turn your attention to the future. Unless you’re expecting a huge company pension or inheritance, your next priority should be to put a comfortable retirement on autopilot.

U.S. citizens can’t even think about relying exclusively on Social Security payments for retirement. The average benefit is $1,000 per month, less than the poverty level. And no one knows the future of the program.

It’s your responsibility to fund your own retirement by investing on a regular basis as early as possible. If you have a retirement plan at work, such as a 401k or 403b, that’s the first place your savings should go.

Don’t have a workplace retirement plan or are self-employed? No problem, just about everyone can have an IRA (Individual Retirement Arrangement). And there are accounts for the self-employed, such as a SEP IRA or Solo 401k. In general, you can even max out multiple retirement accounts in the same year.

Workplace plans are loaded with benefits including automatic payroll deductions, employer matching, and federal legal protection from creditors. Depending on the state where you live, different types of IRAs may also come with legal safeguards that keep your funds safe.

Make a commitment to always invest a minimum of 10% to 15% of your gross income each year. If you do that consistently for decades, it’s easy to accumulate at least a million dollars to spend in retirement.

So, until you’re regularly investing some amount for retirement (even if it’s small), don’t think about paying off debt ahead of schedule. Put your own retirement ahead of creditors, otherwise you risk getting started too late and may not have enough time to catch up and build enough to live on after you stop working.

3. Pay off debt.

After you’re prepared for the unexpected and are consistently investing for the future, it’s time to tackle your debt. But not all debt is created equal, so you need a strategy to choose the best accounts to eliminate first.

Your goal should be to figure out what’s more profitable: saving the interest you’re currently paying on debt or investing money with the expectation that it will grow. Ask yourself, which option brings me the highest return on my money?

Paying off debt gives you a straightforward, guaranteed return. For instance, if you’re carrying debt on a credit card that charges 26% interest annually, paying it off is an immediate 26% return.

You’d be hard-pressed to find an investment that would pay you a 26% return after taxes. So, paying off that high interest debt is a much smarter financial move than investing. But it’s a tougher call when you have more reasonable debt, such as a 4% mortgage or a 5% student loan.

How Taxes Affect Interest Rates on Mortgages

What complicates the debt-versus-investing issue is that taxes come into play. They’re important to consider because they make some investments less profitable and some debts less expensive.

Tax-deductible debts include student loans, mortgages, home equity loans, and home equity lines of credit (HELOCs). Some amount of interest you pay for these debts can be deducted from your taxable income, which reduces the amount of tax you owe.

In other words, a 4% mortgage costs less on an after-tax basis, assuming you claim the mortgage interest tax deduction. The only requirement for eligibility is that you itemize deductions on Schedule A. The after-tax rate depends on your tax filing status and income.

What complicates the debt-versus-investing issue is that taxes come into play. They’re important to consider because they make some investments less profitable and some debts less expensive.

Let’s say you have a $200,000 mortgage at 4% and pay $8,000 in interest this year. If your average income tax rate is 25%, deducting $8,000 in interest from your taxable income save you $2,000 ($8,000 x 0.25 = $2,000) in taxes.

So, instead of paying $8,000 in mortgage interest, you really pay $6,000 ($8,000 - $2,000) after taxes. Dividing the real amount of interest paid by your mortgage balance gives you a real interest rate of just 3%, not 4%.

You’re allowed to deduct the interest you pay on first and second mortgages for up to $1 million in mortgage debt (or up to $500,000 if you’re married and file taxes separately). The limits are lower for home equity loans and HELOCs. If you use them to buy, build, or make improvements to your home, you can generally deduct interest on debt amounts up to $100,000 (or up to $50,000 if you’re married filing separately).

How Taxes Affect Interest Rates on Student Loans

The same calculation works for student loans, except that there are several annual limits to keep in mind. To be eligible to take the student loan interest deduction in 2017, you must have modified adjusted gross income that’s less than $80,000 for single filers or less than $160,000 for joint filers. (There’s no income threshold for the mortgage interest deduction.)

There’s also a much lower limit on how much interest you can deduct compared to mortgages. You can only claim a total of up to $2,500 of interest each year on federal or private student loans for you, your spouse, or your dependents.

Let’s say Jennifer has a student loan balance of $100,000 at 5% interest, which costs her $5,000 this year. She and her spouse earn $150,000 and file a joint return, making them eligible for the student loan interest deduction.

If they pay an average income tax rate of 20%, the $2,500 deduction saves $500 ($2,500 x 0.2). Now, instead of paying $5,000 in interest, Jennifer pays $4,500. If you divide $4,500 by her loan balance of $100,000, her student loan interest rate after taxes is reduced from 5% to 4.5%.

Now you know how tax deductions cut the interest rates you pay for mortgages and student loans. Unfortunately, other types of debt—such as credit cards, store cards, car loans, personal loans, and payday loans—don’t come with tax deductions, so their rates don’t change after taxes. That’s why, as I previously mentioned, a credit card charging 26% really costs you 26%, because none of the interest is deductible.

To correctly evaluate whether to pay off a debt early or to invest, the first step is to figure out what you’re really paying for it after taxes. Then you can compare it apples-to-apples to the money you could earn after taxes by investing it and see which option is more profitable.

How Taxes Affect Your Investment Returns

Now, let’s focus on how taxes affect your investments. Most investment earnings are taxable, except those owned inside a tax deferred or tax free qualified retirement account, such as an IRA or workplace 401k.

Let’s say you have plenty of emergency money sitting in the bank, invest 15% of your income for retirement, and still have $200 a month left over. First, use it to pay down any debt with double-digit interest rates, such as credit cards, payday loans and car loans.

Don’t have any dangerous or high-rate debt? Congratulations, you’re in a great spot! Now’s the only time you should entertain the idea of paying off tax-deductible debt (mortgages and student loans) or investing your spare cash.

Go back to my earlier example of a 4% mortgage that really costs 3% after taxes. Paying it off early gives you a guaranteed 3% annual return. Can you find a more profitable way to use your extra money to yield a higher after-tax return?

I believe you can earn more by investing than by paying off a typical mortgage. It’s not difficult to find investments that would give you a higher return, including fees. But investing always involves some amount of risk, so there are no guarantees.

A good choice would be to invest $200 a month in a Roth IRA, which allows earnings to grow tax-free, maximizing your return. You’d only pay income taxes on money in the year you make Roth contributions and then withdraw them in retirement with zero taxes due.

Pros and Cons of Paying Off Debt Before Investing

When you have debt with double-digit interest rates, such as a 12% credit card or a 10% car loan, there’s no debating that your best financial move is to wipe it out when you have extra money. But before you prepay a low-rate debt, that come with tax deductions, consider various pros and cons.

Some would argue that getting rid of a low-interest debt is better than investing money, even if you miss out on higher potential returns, because it gives you peace of mind. The idea is that you’d enjoy a guaranteed return, even if it’s very low and quite conservative.

The flip side of the argument is that you could invest money to build wealth at a much higher rate than you’re paying for a mortgage or student loan. Plus, paying off a low-interest loan early could leave you cash-poor in the case of an emergency.

Once you sink money into paying off a mortgage or HELOC, it could be difficult or impossible to cash out your home equity if you needed it. The value of your home could go down or your credit worthiness could plummet and you may not qualify for a refinance in a financial pinch.

Also, having a fixed, low-rate mortgage can be a smart hedge against potential inflation. If interest rates go up, your mortgage payments stay the same would effectively cost less in the future than they do now.

Should You Pay Debt or Invest?

There’s a lot to consider in the debt-versus-investing question. My advice is to invest your extra money when the after-tax earnings should be higher than the after-tax interest rate you're paying on debt.

However, the best choice for you depends on your risk tolerance. It’s called personal finances because we’re all different. Decisions that make you feel comfortable may seem very risky to the next person.

If you still feel conflicted about the debt-versus-investing issue, one solution is to do both. You could send half your extra money to prepay debt and half to an investment.

Once you take care of yourself by building an emergency fund, having insurance, and investing 10% to 15% for retirement, how you prioritize extra money is your call. Get clear about your goals and make sure how you spend money always aligns with your values.

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all about How To

Rabu, 26 Juli 2017

Should You Pay Off Debt Before Investing?