Investing or Paying Down Debt, What's Better?

Most financial pundits will advise you to pay down debt as fast as you can since it acts as a drag on your overall finances. Having debt overall just sucks and the sense of accomplishment of paying off your debts can be an extremely positive feeling. However, is aggressively paying down debt the best option? Let’s take a look at some reasons why making the minimum payments may make sense.

“Good” or “Bad” Debt:

Not all debt is created equal and it is important to understand how different types of debt work. Certain types of debt have tax advantages. For example, interest payments on mortgages (including home equity lines of credit otherwise known as HELOCs) and student loan debt are tax deductible. Credit card interest payments are not tax deductible. It is generally more advantageous to pay down credit card debt before making extra mortgage payments.

Interest Rates:

Knowing the interest rates on your debt is very important. Most credit cards charge more than 12% while most mortgages currently are around or under 4%. Does it make sense to make extra payments on a loan that is charging your 4%? Can you earn more money elsewhere? Let’s use an example of an original mortgage of $400,000 with a 4% interest rate and a 30 year mortgage. That would mean your monthly mortgage payment is $1,910. What would it look like if you paid one extra month towards your mortgage then investing the mortgage payments compared to investing the $1,910 each year (at 6% interest) for the next 30 years?

As you can see, the mortgage is paid down at a faster rate, but that ends up costing you about $13,000 over the long haul. That doesn’t even include the tax deductions for the mortgage payments.

Cash Flow:

Most people want to have their houses paid off at retirement and that is understandable. People often fail to realize how important cash flow is in retirement. Unfortunately, in life, issues always come up. The car breaks down, the roof needs fixing or you may have a medical emergency. Money that is tied up in your home’s equity is not easily accessible. You have three options, take out a HELOC (which brings more debt), utilize a reverse mortgage (which is another form of debt), or sell the house (which is not a quick or easy process). Making sure you have access to cashflow in retirement is crucial. Is it better to have your mortgage paid down or to have access to cash when you need it? 

Sitting down with a financial professional can be a useful exercise when it comes to analyze whether it's better to pay down your debt or invest. Everyone's situation will be different, but it pays off to have a good baseline understanding of how debts can impact your life.