Paying Down Debt Vs. Investing
Debt is awesome. Without debt, our government couldn’t build roads or schools, corporations wouldn’t be able to develop new products, and consumers wouldn’t be able to afford schooling, cars, or homes. As a society, one of the problems that we struggle with is how fast to pay off debt and what debt we should be prioritizing.
Debt has the ability to trick us. We forget that when we buy a $25k car, it actually costs 35k with interest, that $80k in student loans will end up costing $140k, or the $400k house will cost $700k by the time it is paid off. But that doesn’t necessarily mean you should be paying off debt instead of investing in retirement or general savings. Car loans, student loans, and mortgages for the most part all charge you less than 7 percent interest. When interest on debt is less than 7 percent (the average return from the stock market), it is better to stick to a repayment schedule for your debt and prioritize saving money in the stock market.
Make Payments on Debt Then Invest
Sticking to ‘good’ debt requires two steps. First, make regular payments on your debt, and avoid taking on unnecessary debt such as credit cards or buying a car house that is more expensive than you need. Second, focus on building investments. Mortgages are the best example. There is nothing stopping you from putting extra money towards paying off your mortgage sooner than required, but it would be better to put that money into the stock market. In the second year of a 30-year mortgage, you could put an extra $1,000 towards paying off your mortgage sooner, reducing your bill by $2,180 over the lifetime of the loan. But it would be smarter to put the extra $1,000 in the stock market, making you $6,570 over the same time period. I wrote about investing strategies here.
Prioritize Paying off Debt
Credit Card debt should be avoided. Interest rates for even the best cards are in the teens and most credit cards have interest rates of 20 to 30 percent. Credit card points on purchases are nice, but any late payments make the benefits quickly evaporate. Work hard to avoid this debt and pay it off quickly.
Car Loans usually have low rates for people with good credit, but don’t have the tax benefits that come with student loans or mortgages. Car loans also require people to pay them off in a shorter amount of time. Additionally, a car is a depreciating asset and should never be thought of as an investment. If you are trying to pay down debt, try to avoid buying more car than you need. Buying cars that have better fuel efficiency and longevity also help pay down debt in the long term.
Student Loans do have some tax advantages if you have federal loans. If you make under $80k you can deduct a portion of the interest you pay on student loans up to $2,500 — it doesn’t matter if you itemize or take the standard deduction. Think of this deduction as lowering the interest rate on the loans. Interest rates on student loans vary from 4 percent to 8 percent. If you have multiple student loans, prioritize paying off higher interest rate loans first. Also, some companies allow you reduce the interest rates by a quarter percentage point if you set up automatic payments. However, if you have private loans, it is smart to try and refinance the loans with a company that offers lower interest rates.
Mortgages come with a very lucrative tax deduction, but only if you itemize your taxes. In 2019, you can deduct mortgage interest up to $750,000 of debt on a home purchase. Interest rates are fairly low right now, a little over 4 percent. However, the deduction is most helpful to higher income families. If you’re in the top income bracket (37 percent) the deduction is more useful than when you’re in the 22 percent tax bracket. Also, make sure that you are making steady payments. Unlike other debt, homes traditionally appreciate in value. However, buying a bigger house due to the mortgage interest deduction is a trick. Avoid buying more of a house than you need. I wrote about some of the dangers of the 30-year mortgage here.
There is a certain amount of self-control required to follow this strategy. If saving money in the stock market makes you feel richer and spend more, that defeats the purpose and it might have been smarter to just pay of debt. Make sure that you set long-term goals and then stick to them! Also, if you want to read why rich people don’t keep money in a bank account I wrote about it here.