Should You Pay Off Debt Before Investing?

Welcome to the money girl podcast. I’m Laura Adams, a leading personal finance and small business expert. And award-winning author. I’ve been hosting this show since 2008, and I’m thrilled that you’re here. I’m thrilled to have you as a listener, no matter what want to achieve with your money. It all starts with financial literacy. This show is for everyone who wants more financial wellness, knowledge tips, and down to earth, practical advice, no matter your age. My goal here is to help you live a healthy, enriched life by making the most of what you have planning wisely for the future and making smart money decisions. Being a wise money manager and building wealth is a marathon, not a sprint. If you’re feeling frustrated about not being where you wanna be with your money, or maybe you’re doing great, but you just got questions about things like credit debt, retirement, investing, insurance taxes, real estate, business, money, mindset, and more you’re in the right place.

We cover all those topics in the show. Last week, I was out of town for a few days, celebrating a friend’s wedding in new samrna beach. We had an amazing time. I haven’t danced that hard in a long time. So I pulled a great show from the archives for you that I hope you’ll enjoy. And I’ll be back next week with a brand new show. Getting your finances in shape is exactly what today’s show is about. So if you’re ready to get more clarity about how to make important financial decisions and really get serious about making progress, stay with me. I think you’ll love this show. This is episode number 506 called should you pay off debt before investing to see notes from this episode, go to the money girls [email protected]. And there you’ll see a section called money girls, recent tips. And if you’re looking for the full archive of podcasts, they’re also on the money girls [email protected].

They’re in a section under the tips called money girls archive, not being sure about whether to use your spare cash to pay off debt or to invest. Is it really common dilemma? I hear this question from a lot of different people, bold, no matter their age or stage in their finances. And it’s definitely important to accomplish both, but you’ve only got so much money to go around. So how do you know which to focus on first, if you’re not sure about the next move to make, it’s easy to feel stuck and never make progress with your personal finances. So in this podcast, I’m gonna cover the main pros and cons of paying off debt before investing. Plus, I’m gonna give you a simple method to prioritize your precious resources so you can accomplish key financial goals and build wealth as quickly as possible too often.

I think we get bogged down by a specific financial decision or a specific dilemma without kind of picking our heads up and considering the big picture of our financial life to make the best decisions you’ve gotta step back. That’s really wise. Step back, take a holistic view of your entire financial life. And I think that will help you make decisions. I created a simple three pronged approach that I call the PIP plan P I P. And those letters stand for prepare, invest, and pay off. I’d like you to use this as a touchstone when you’re considering how to allocate your money wisely. So consider doing these in order and we’ll go through them one by one. So the first is prepare for the unexpected life is full of surprises, right? And you probably know that many of them can seriously drain your bank account. So before spending a dime on debt or investments, ask yourself if you’re really prepared for the unexpected in an instant, you could lose your job.

You could see your business income dry up. You could get a serious illness, lose a spouse or experience a natural disaster. I know it’s not fun to think about all these different types of devastating situations, but they happen. They happen every single day while no amount of money can reverse these types of tragedies. Having a financial safety net can make them so much easier to cope with. So what you are going to need for your life and what could come up that’s unexpected is going to depend on factors, such as your living expenses, your debt payments, your income, and whether you have dependence at a minimum. I want you arrive to maintain an emergency fund equal to three to six months worth of your living expenses. For instance, let’s say you spend $3,000 a month on essentials. Those might include housing, utilities, food and debt payments.

If that’s your level of essential living expenses, make a goal to keep at least three times that amount or $9,000 in an F D I C insured bank savings account. And I can already hear many of you saying, oh my God, that’s way too much money. I can never accumulate that much. Well, you gotta start somewhere. Uh, I would say if accumulating three, your living expenses seems just way outta reach. Don’t worry. Just get started with a small goal, such as saving a hundred dollars, 500, and then a thousand until you have at least one month’s worth of security on hand. And of course, I want you to continue building that up until you’ve got, as I said, a minimum of three to six months worth of expenses, but having even a small cash reserve is better than nothing, right? Because that can be the difference between into debt or staying safe.

That small amount can keep you from getting into trouble in the first place. If you hit a financial, rough patch in your life and who has not hit a financial rough patch in their life, it’s happened to all of us and it’s likely going to happen to all of us in the future. So you always want us to a prepared and I talked a lot more about emergency money and podcast number 401 called should you invest emergency money or keep cash in that show? I cover a lot more about how to calculate how much reserve money you need and the best places to keep it. In addition to maintaining enough emergency money, to stay safe. Another key way to prepare for the unexpected and to stay out of debt is to have the right kinds of insurance being underinsured or uninsured means that a disaster, a theft or an accident could wipe out everything you’ve worked so hard to earn and could jeopardize your entire financial future.

For starters, if you drive, even if you don’t own a car, you could hurt someone and you could get sued for expensive injuries and medical payments. Having just the minimum amount of liability on your car insurance oftentimes is not enough for if you’re in Florida, you’re only required to purchase $10,000 in auto insurance liability. If you were found guilty for injuries totalling, let’s say a hundred thousand dollars to someone you’d be on the hook for the balance of $90,000, you could get into a lawsuit that could garnish your wages. It could be a really bad situation. Uh, then there’s also homeowners and renters coverage. If you’ve got a mortgage, lenders are gonna require you to have home insurance, but most renters go uninsured. And that’s a big, big mistake. Renters insurance is a bargain for the protections that you get. And it, it might cost less than $200 per year.

On average, just like a homeowner’s policy. Renter’s insurance covers some amount of your personal belongings, your liability and your living expenses. If you’re forced to move out after a disaster and all of those coverages are customizable, so you can increase them or decrease them as you like the more income and assets you have, the more coverage you need to stay safe. So consider adding an inexpensive umbrella liability policy for additional protection above and beyond what you already get on your auto or your home or renter’s insurance. And no matter what does or doesn’t happen to the affordable care act known as Obamacare, everyone should have health insurance to protect your finances. All it takes is one, visit it to the emergency room or a short stay in the hospital to rack up a massive medical bill that could turn your financial world upside down. And the last insurance that I’ll mention to stay safe is life insurance.

Life insurance is a must for anyone with family who would be hurt financially. If you died, you can protect loved ones with a pretty inexpensive term life policy. It may not cost more than about $200 a year for a half a million dollar benefit. If you’re in relatively good health. The bottom line is that if you don’t have an emergency fund and you don’t have insurance, that’s critical for you and your family safe, D you’re not ready to pay off debt ahead of schedule or to invest. Now, the only exception I’d say would be to pay off any dangerous debt that you might have. These could include really serious things like overdue child support, tax liens, and accounts in collection. These are important to address quickly because they can w reak havoc on your entire financial life. So those types of dangerous dents need to be addressed as quickly as possible.

Okay? So we’ve covered the P in my PIP plan, which is prepare for the unexpected. The I stands for invest for the future. Once you’re prepared for the unexpected events, that could be around the corner. It’s time to turn your attention to the future, unless you’re expecting a big company pension or inheritance, your next priority should be to put a comfortable retirement on autopilot. And unfortunately you, us citizens cannot even think about relying exclusively on social security payments for retirement. The average benefit is just $1,000 per month. That’s less than the poverty level. Social security was never meant to be your sole resource for retirement. And of course, no one knows the future of that program. So it’s your responsibility and no one else’s to fund your own retirement by investing on a regular basis as early as possible. If you’ve got a retirement plan at work like a four oh Onek or a 4 0 3 B, that’s the first place that you’re savings should go.

Now don’t freak out. If you don’t have a workplace plan, maybe you work in a small company that doesn’t have a plan offered to employees, or maybe you’re self-emploed, it’s no problem just about everyone can have an IRA or individual retirement arrangement. And there are even accounts for the self-employed such as ACE IRA, or a solo 401k. And if these are of interest, I’ve done shows on these types of retirement plans. One that you might look at is podcast number 422 called five retire options. When you’re self-employed, and in general, you can even max out multiple retirement accounts in the same year. Workplace plans are some of my favorite though, because they’re loaded with benefits, including automatic payroll, deductions, employer matching, and federal legal protect from creditors. And depending on the state where you live different types of IRAs may also come with legal safeguards that keep your funds safe.

So I want you to make a commitment to yourself right here, and right now to always invest a minimum of 10 or up to 15% of gross income for retirement each year, if you do that consistently for decades, it’s actually easy to accumulate at least a million dollars to spend in retirement. So until you’re regularly investing some amount for retirement, even if it’s a small amount, don’t think about paying off debt ahead of schedule, all, put your retirement first, put your own future ahead of creditors. Otherwise you risk getting started too late, and you may not have enough time to catch up and build enough wealth to live on after you stop working. Okay. The third part of my PIP plan is to pay off debt after you’re prepared for the unexpected and after you’re consistently investing for the future, it’s time to tackle your debt, but you need to be aware that not all debt is created equal.

So you need a strategy to choose the best accounts to eliminate. First, your goal should be to figure out what’s more prom able, saving the interest that you’re currently paying on a debt or investing money with the expectation that it will grow. You’ve gotta ask yourself which option brings me the highest return on my money. In some cases, it’s gonna be crystal clear. In some cases it’s a little more or hazy, and that’s because paying off debt gives you a straightforward, guaranteed return. For instance, let’s say you’re carrying debt on a credit card that charges a really high interest rate. It’s charging you 26% annually. So if you pay that card off you’re to get an immediate 26% return on your money. That’s awesome. You’d be very hard pressed to find an investment that would pay you 26% after taxes. So paying off that high interest debt is a much smarter financial move than investing. But as I mentioned, it’s a tougher call when you’ve got more reasonable debt, such as a 4% mortgage or a 5% student loan. And what complicates the debt versus investing issue is that tax is coming to play. They’re important to consider because they make some investments less profitable and some debts less expensive.

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Now, they’ll switch you over for free head to policy genius.com to get started right now, policy genius, when it comes to insurance, it’s nice to get it right. There are only a few tax deductible debts that you might have. And these include student loans, mortgages, home equity loans, and home equity lines of credit or helocks. So they’re basically either student loans or some type of mortgage, some amount of interest that you pay for these debts can be deducted from your taxable income, which reduces the amount of tax you owe. And this is important because that reduces the interest rate that you’re paying. So in other words, a 4% mortgage actually costs less on an after tax basis. Assuming you claim the mortgage interest tax deduction, the only requirement for eligib is that you itemize deductions on schedule a, of tax form 10 40 and the after tax rate that you end up paying depends on your tax filing status and your income.

Here’s an example. Let’s say that you’ve got a $200,000 mortgage and you’re paying 4%. So at that rate, you’re gonna pay $8,000 in interest this year. If your average income tax rate is 25%, if you deduct $8,000 in interest from your taxable income, you save $2,000 in taxes. So instead of paying $8,000 in mortgage interest, you really pay $6,000 after taxes dividing. The real amount of interest that you pay by the mortgage balance gives you a real interest rate of just 3%, not 4%. And by the way, I’ll put the math for this example in the show notes, which will be in the money girls [email protected]. You’re allowed to deduct the interest you pay on first and second mortgages for up to a million dollars in mortgage debt, or up to half a million. If you’re married, file taxes separately, and the limits are lower for home equity loans.

And helocks, if you use one of those types of loans to buy, build, or make improvements to your home, you can generally deduct interest on debt amounts up to 100,000 or up to $50,000. If you’re married and file taxes separately. And if you’re interested in learning more about helox, I did a recent show, it was number 496, where I interviewed a HeLOCK expert. If you wanna dive into that topic further, now the same calculation works for student loans, except that there are several annual limits to keep in mind to be, to take the student loan interest deduction. In 2017, you must have modified adjusted gross income. That’s less than $80,000 for single filers or less than 160,000 for joint filers. And by the way, there’s no income threshold to take the mortgage interest deduction that’s available, no matter how much you earn, as long as you itemize deductions on schedule a and for student loans, there’s also a much lower limit on how much interest you can deduct compared to mortgages.

You can only claim a total of up to $2,500 of interest each year on federal or private student loans for your spouse or your dependenence. So let’s say that Jennifer has a student loan balance of a hundred thousand dollars at 5% interest. That’s costing her $5,000 this year. She and her spouse earn $150,000 and file of joint return. So that makes them eligible to take the student loan interest in duction. If they pay an average income tax rate of 20%, the $2,500 deduction will save them $500 on their taxes. Now, instead of paying $5,000 in interest, Jennifer pays $4,500 after you factor in that $500 savings that she’s getting on her taxes. If you divide $4,500 by her loan balance of 100,000, her student loan interest rate after taxes is reduced from 5% down to 4.5%. Now you’ve got a basic understanding on how tax deductions cut the interest rates that you pay for mortgages and student loans.

Unfortunately, other types of debt like credit cards, store cards, car loans, personal loans, and pay day loans do not come with tax deductions. So their rates don’t change on an after tax basis. That’s why, as I previously mentioned a credit card charging you 26% really cost you 26% because none of the interest is deductible to correctly evaluate whether to pay off a debt early or invest your money. Instead, the first step is to figure out what you’re really paying for it after taxes. Then you compare it apples to apples, to the money you could earn after taxes, by investing and see which option is more profitable. So now let’s talk about how taxes affect your investment. Most investment earnings are taxable, except for those owned inside a tax deferred or a tax free qualified retirement account, such as an IRA or a workplace 401k, which is one of the reasons I’m always recommending these accounts that come with really great tax benefits.

Let’s say you’ve got plenty of emergency money sitting in the bank. You invest 15% of your income for retirement, and you’ve still got $200 a month over. You’re wondering, what do I do with them? Well, first use it to pay down any debt with double digit interest rates. So these are probable credit cards, payday loans, and maybe car loans. And if you don’t have any high rate debt or dangerous debt, pat yourself on the back, you are in a really great position. Now is the time that you should entertain the idea of paying off tax deductible debt like these mortgages and Stu and loans that we’ve been talking about. So go back to my earlier example of a 4% mortgage that really costs 3% after taxes paying it off early, gives you a guaranteed 3% annual return. The question to ask is can I find a more profitable way to use my extra money to yield a higher after tax return?

And I believe that you can earn more by investing than paying off the typical mortgage. It’s not difficult to find investments that would give you a higher return, even when you take fees into account, but investing always involve some amount of risk. So there are no guarantees. In my opinion, a good choice would be to invest your extra $200 a month in a Roth IRA, which allows your earnings to grow tax free. And that maximizes your return. You’d only pay income taxes on money in the year. You make Roth contributions, and then you get to withdraw them in retirement with zero taxes due. So let me summarize here and I’ll cover some pros and cons of paying off debt before investing. When you’ve got debt with double digit interest rates, like a 12% credit card, or even a 10% car loan. There’s no debating that your best financial move is to wipe it out when you’ve got extra money.

But before you prepay a low rate debt, that also comes with tax deductions. I want you to cons that are some various pros and cons because the benefit is not quite so clear. You might come out ahead investing. Some people are going to argue that getting rid of a low interest debt is better than investing money. They might say, well, even if you miss out on some higher potential investment returns, at least you get peace of mind when you pay off a low rate debt, you know that you’re going to enjoy that guaranteed return, even if it’s very low and very conservative. But the flip side of that argument is that you could invest money to build wealth at a much higher rate than you’re paying for low rate mortgage or student loan. Plus paying off a low interest loan early could leave you cash poor in the case of an emergency.

So think about it. Once you sink money into paying off a mortgage or HeLOCK, it could be difficult or even impossible to cash out your home equity. If you needed it, it, the value of your home could go down or your credit worthiness could plummet. Maybe you lose your job and you may not qualify to refinance your home in a financial pinch. Also, having a fixed low rate mortgage can be a smart hedge against potential inflation. If interest rates go up, your fixed mortgage payments stay the same and they would definitely cost you less in the future than they do now. So for all of these reasons, I am not a fan of pre-paying a mortgage or a student loan ahead of schedule. I would recommend making those minimum payments and hanging onto your cash. And instead for a higher return, as you can see, there’s a lot to consider in the debt versus investing question.

Again, my advice is to invest your extra money when the after tax earnings should be higher than the after tax interest rate that you’re paying on the debt. However, the best choice for you depends on your risk tolerance. We call it personal finances because it’s personal. We’re all different decisions that make you feel comfortable may seem very risky to the next person. So if you still feel conflicted about the debt versus investing issue, one solution is to do both. You could send half your extra money to prepay a debt and half to an investment. And once again, if you’ve got high rate debt, there’s no debating it. You need to get rid of that high rate debt before you invest. So we’re all they talking here about prepaying, low rate debt, like mortgages and student loans. Once you take care of yourself by building an emergency fund, having insurance and investing 10 to 15% for retirement, how you prioritize extra money is really your call.

The best device I can give you is to get very clear about your financial goals. What do you want to accomplish and make sure how you spend your money aligns with those values and goals. Thanks so much for listening today. If you’re getting value from the show, the best way to give back and let me know is to take a moment to submit a quick five star review in apple podcasts or wherever you download shows like Stitcher or SoundCloud. And if you wanna keep the money conversation going with a thriving community of thousands who are taking their financial game to the next level, you definitely need to join us in my private Facebook group called dominate your dollars. Check it out over on Facebook, or request an invitation by sending me a text message for immediate access. Just text dollars, D O L L a R S to the number 3, 3, 4, 4, 4. I’ll see you in the group. You can also visit Laura D adams.com where you’ll find my I contact Paige and more about me, my books and online courses. That’s all for now. I’ll talk to you next week until then here’s to living a richer life. Money girl is a quick and dirty tips podcast. It’s audio engineered by Steve rickyberg with script editor by Adam Cecil. Our operations at editorditorial Royal manager is Michelle margulus. Our assistant manager is Emily Miller and our marketing and publicity assistant is devivinna Tomlin.

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