Use extra cash to invest or to pay off debt? Here are some options
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As a financial advisor, a common question I receive revolves around the decision between paying down debt and investing when there is an opportunity.
A bonus, tax refund, or other win can often result in extra cash.
As we work our way through Covid-19, many questions are prompted by someone who has been given a severance deal.
You should carefully consider whether you are going to invest or pay off debt, regardless of where it came from.
Many financial professionals recommend that you first pay off your debt.
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Both for financial reasons and for non-financial ones, there are strong arguments in favor of this. Financially, the debt is paid and you are no longer paying interest — and those are good things.
These benefits can also be psychological or emotional. The idea of mortgage-burning parties was once a huge deal. The parties were meant as celebrations of being true property owners, without the risk and responsibility of the property being encumbered.
It was not necessary for homeowners to be concerned about what might happen in the event of a job loss or other economic difficulties. You can rest easy knowing you have a roof to protect your head.
On the other hand, some think that investing money should be done if the after-tax return of investments exceeds the after-tax cost for your debt.
An example of this is: A debt has an interest rate at 4%. The interest will be deducted.
Let’s now assume that investment returns are 8%. Assuming you fall within the marginal tax bracket at 22%, your effective cost of debt is 3.12%. This compares to a 6.24% after-tax return.
It makes financial sense in this situation to invest and only pay what you owe.
It is possible to compare a specific debt cost with an uncertain investment return.
Now, there’s a third option in the payoff-debt-versus-invest debate, and it can be summed up with a quote from Yogi Berra, a brilliant baseball player and manager. Yogi is also known for his humorously wise sayings which were called “Yogi’isms.” One of his more famous quips reminds of that third option: “When you come to a fork in the road, take it.”
It doesn’t need to be a binary decision about whether to invest or pay off your debt. Try both.
This allows people to have both their cake AND their pudding.
Not only do you save on interest, but also the money can be invested. If you do not have sufficient funds to pay off the whole debt, then this option is especially attractive.
For many, investing is more enjoyable than saving money or reducing interest expenses. It’s also a good idea to get into the habit and invest now, rather than waiting until later.
It doesn’t matter what option you pick, take time to consider it, create a plan, and execute it.
In other words, use the roadmap that works for you. Yogi stated: “If your destination is unknown, you will end up somewhere else.”