Paying Down Debt vs. Investing: Which Should Come First?

If you have extra cash each month, should you make extra payments on debt or invest for the future? The guidance provided in this article is general in nature, and one must consider various factors including those listed below. This is not a one-size-fits-all decision — the right answer depends on interest rates, risk tolerance, tax deductibility, and overall financial goals. ­­

1. Compare Opportunity Cost – Interest Rate on Debt vs. Expected Return Rate

Paying off debt generally offers a guaranteed rate of return equal to the stated interest rate. A good rule to follow is: If the interest rate is HIGHER on the debt than what you reasonably expect to earn by investing, then prioritize debt payments. Some examples are listed below with hypothetical interest rates:

• Credit Card Debt (15-25%): Paying off credit cards first is generally best due to the high interest rates that are typically charged. Earning rates of return higher than credit card rates demands substantial risk-taking and sustained market outperformance — a combination that’s historically very difficult to accomplish.

• Mortgage (3-5%): Can be better to invest, however one should consider other factors including: how long one anticipates owning the subject property, tax deductibility, likelihood of a refinance, risk-tolerance, and proximity to retirement.

• Student Loans (5-9%): May be a bit of a gray area; one should compare their rates against their expected portfolio returns.

2.      Evaluate Risk Tolerance and Emotional Impact

Some individuals may prioritize debt freedom or increased cash flow for the peace of mind it provides, even if investing could potentially yield a higher return. While investing may have the potential for greater growth, those returns are not guaranteed. That’s why it’s important to ask whether you’re comfortable taking on the level of risk required to potentially outperform your debt’s interest rate — especially when paying it off provides a risk-free, guaranteed return.

3.      Consider Tax Benefits:

Investing in tax-advantaged accounts like a 401(k) or Roth IRA can offer valuable tax benefits, either now or in the future. Certain forms of debt, such as mortgages, student loan interest, or car loan interest may be tax-deductible depending on factors like income, filing status, loan size, and whether you itemize deductions. To fairly evaluate tax-deductible debt vs. investing, it can help to estimate the after-tax cost of debt using this formula:

After-Tax Interest Rate = Interest Rate on debt x (1 – Marginal Tax Rate)

**For example: a 6.00% mortgage, with a Federal marginal tax rate of 24.00%, and 0% State tax rate may result in an after-tax cost of 4.56% = 6.00% x (1 - 0.24). Thus, in this scenario, one should compare the after-tax cost of 4.56% to their expected rate of return on investments. Please visit the footnotes of this blog to read more information about the nuances of tax deductibility tied to various loan types.

4. Employ a Hybrid Strategy:

A balanced approach may work well for someone who has eliminated their expensive (credit-card) debt. An example of a hybrid strategy would be: Contribute enough to receive a full match from your employer sponsored retirement plan and then split the remaining extra cash flow 50/50 between debt and investing.

Deciding whether to prioritize debt repayment or investing isn’t always straightforward — it depends on factors like interest rates, tax implications, cash flow needs, risk-tolerance, overall financial goals, and other factors not listed above. A financial advisor or tax professional can help you evaluate your specific situation and determine an effective strategy to align with your long-term goals.

**The example above assumes full deductibility of interest, which may not apply in every case. Mortgage interest is only deductible if you itemize deductions and may be limited to interest on the first $750,000 of mortgage debt (for loans originated after Dec. 15, 2017). Student loan interest is also subject to income-based phaseouts. Additionally, the tax benefit may change over time based on your loan’s amortization schedule, your filing status, and evolving tax law. Please consult a tax professional to evaluate how these rules apply to your situation. For more information on mortgage interest deductibility, click here. For more information on student loan interest deductibility, click here. For more information on car loan interest deductibility, click here.