Paying down debt should always be considered in making investment decisions. For example, paying off high-interest credit card debt is almost always your best investment. Paying down lower-interest debt, especially if the interest is tax deductible, is a harder decision, but it should be considered. Let’s look at some examples to illustrate the tradeoffs.
Paying off $1,000 of credit card debt with an interest rate of 10% is comparable to getting a guaranteed 10% tax-free return on a $1,000 investment; that’s an incredible return in today’s low-interest rate environment. By paying off $1,000 of debt at 10% you’ll save $100 in interest in a year. You’re likely to only get $1 - $10 in interest on $1,000 sitting in a bank or money-market account for a year. So, by paying of the credit card debt you’re $90 - $99 ahead at the end of the year.
Sure, by investing in stocks, you might make 30% or more in a year—but you also might lose 30% or more. A reasonable long-term expectation for stock market returns is maybe 5%-8%, but there’s significant uncertainty in this expectation. Choosing to invest in anything rather than to pay off debt is like borrowing the amount you owe to invest. Would you borrow money at 10% to invest in stocks? If not, then you should pay off any 10% debt before investing in stocks.
What about a mortgage with a 5% interest rate? If you have extra cash sitting in a bank or money market account earning 1%, then you’re essentially borrowing at 5%, less your tax savings, to invest at 1%. To illustrate, say you have a $100,000 mortgage with a 5% interest rate (fixed) and have $100,000 in a bank account earning 1%, and assume your tax rate is 20%. In this case, after one year your situation is as follows:
- mortgage interest: -$5,000
- tax savings on mortgage interest: +$1,000
- interest on savings: +$1,000
- taxes on savings interest: -$200
This results in a net expense of $3,200. Instead, if you use the money in the bank to pay off the mortgage, your net expense for the year is $0 (all numbers in above list are $0), putting you $3,200 ahead for the year.
This should help clarify that the common objection about losing your tax deduction is not a rational reason to not pay off a mortgage. The tax deduction simply lowers your effective interest rate. As long as the after-tax interest rate on the mortgage is higher than the after-tax interest rate you are earning on your cash, then you save money by using the cash to pay down the mortgage.
On the flip side, by using the cash to pay down debt you lose liquidity; i.e., the ability to do something else with the cash. Also, if interest rates rise dramatically, and you have a fixed-rate loan, you could end up being better off with the cash invested at the higher future rate. In the example above, if money market rates were to rise above 5%, your cash would be returning more than your mortgage was costing. Here are the numbers at the break-even point (bank interest rate = mortgage interest rate):
So, if your cash is earning exactly the same interest rate you are paying on your mortgage, the interest from your savings is paying your mortgage interest, and the tax deduction for your mortgage is offset by the tax you pay on the savings interest.
Since we don’t know what interest rates will be in the future, a compromise might be to pay off part of the mortgage. You might pay off half, or even 20%-30%, then see where interest rates are in a year. If not a lot higher, maybe pay off another 20%.
You probably want a cash reserve of at least 6 months of living expenses, but any extra cash probably is best invested in paying down high-interest rate debt. Depending on your risk tolerance, you may want to invest in a globally diversified portfolio of stock mutual funds, rather than paying down lower-interest debt. However, you should give serious consideration to paying down any debt that is costing you more than you’re making in any low-interest investment or savings account.