To Invest or to Reduce Debt – that's the question
By William Artzberger
| Updated January
11, 2018
Investors face the dilemma of whether to
pay down debt with excess cash or to invest that money in an attempt to turn it
into even greater amounts of wealth. If you pay off too much debt and reduce
your leverage, you may not garner enough assets to retire. Conversely, if
you're too aggressive, you may end up losing everything. In order to decide
whether to pay down debt or invest, you must consider your best investment
options, risk tolerance and cash flow situation.
Pay Down Debt or Invest?
All debt is not equal. The type of debt
you have can play a role in the decision as to whether to pay it off as soon as
possible or put your money toward investments.
From a numbers perspective, your
decision should be based on your after-tax cost of borrowing versus your
after-tax return on investing. Suppose, for instance, that you are a wage
earner in the 35% tax bracket and have a conventional 30-year mortgage with a
6% interest rate. Because you can deduct mortgage interest (within limits) from
your federal taxes, your true after-tax cost of debt may be closer to 4%.
Student loans are a tax-deductible debt
that can actually save you money. The IRS allows you to deduct the lesser of
$2,500 or the amount you paid in interest on qualified student loans that were
used for higher education expenses, although it phases out at higher income
levels.
If you hold a diversified portfolio of
investments that includes both equities and fixed income, you may find that
your after-tax return on money invested is higher than your after-tax cost of
debt. For example, if your mortgage is at a lower interest rate and you are
invested in riskier securities, such as small cap value stocks, investing would
be the better option. If you're an entrepreneur, you also might invest in your
business rather than reduce debt. On the other hand, if you are nearing
retirement and your investment profile is more conservative, the reverse may be
true.
What Is Your Risk Tolerance?
Risk tolerance is the degree of
variability in investment returns that an investor is willing to withstand.
When determining risk, consider the following:
1. Your age
2. Income
3. Earning power
4. Time horizon
5. Tax situation
6. Any other criteria that's
unique to you
See the attached file for details