Many investors are faced with a challenging dilemma of whether they should pay off some of their debts with excess cash or whether they should invest this cash further to see whether they can accumulate greater wealth. Paying off too much debt can reduce, if you pay off too much debt and reduce your power to influence a situation to achieve a particular outcome and may see them with not enough assets to retire. On the other hand if you do not reduce debt you could end up losing everything. Therefore when deciding whether to reduce debt or invest it is important to consider all investment options with the risks involved and your current cash flow situation.
Investment Options
With regards to the numbers the decision you make should be on the after tax cost of borrowing compared with the after tax return on investing. Therefore if you are in the 35% tax bracket and you currently have a 30 year mortgage with a 6% interest rate, you’re actual after tax debt is 4% as you are able to deduct mortgage interest from federal taxes.
Those holding a variety of investments in their portfolio that includes equities and fixed income, they could find that after tax return on the money that they have invested is greater than their after tax cost of debt. If you have a mortgage with a low interest rate and you choose to invest in riskier stocks, investing is the better option. Entrepreneurs may choose to invest in their business rather than reduce debt however those coming to retirement age with a more conservative investment profile may find this reversed.
Risk Tolerance
When you are determining risk, it is important to consider the following:
- Age
- Income
- Earning potential
- Time horizon
- Tax situation
- Any other criteria that’s unique to you
If you are young and able to make any money you lose you are considered to have a high disposable income with regards to your lifestyle and you possibly also have a higher risk tolerance and able to invest more aggressively rather than paying off debt. However if you have concerns such as high healthcare costs you may also opt to not reduce debt.
You may decide though rather than investing your excess cash you will keep greater cash balances and fixed income investments. The longer you have until you stop working the greater the return that you could enjoy by investing rather than reducing debt this is because historically equities return 10% more pretax over a period of time.
The other component of risk tolerance is whether you are willing to assume the risk. For the aggressive investors they will prefer to invest rather than reduce debt. However if you are the opposite and cannot bear the thought of losing money through investments or having any type of debt you are best to reduce debt. This is a strategy though that can backfire whilst most investors think that reducing debt is the most conservative thing to do, pay off the debt but not eliminating it can have the reverse effect. The best example of this could be an investor who aggressively pays off his mortgage to a very low level is left with very little cash reserves if he then loses his job he will still need to make regular mortgage payments.
Cash and Debt
It is advised by financial advisors that working individuals should aim to have at least 6 months worth of expenses to hand in case of emergency. It is also suggested that they have a monthly debt-to-income ratio of no more than 33% of pretax income. Once you have secured these then you can look to investing or reducing debt, as you will have that cushion should something unexpected appear.
The first thing you should do is to pay off any credit card debt as this type of debt is likely to carry an interest rate that is higher than most investment earnings. Reducing the debt will save on the amount of interest that you have to pay.
It is worth remembering though some debt such as a mortgage is not a bad debt. If you have a good credit rating the after tax return on your investments will probably be higher than your after tax cost of debt on your mortgage. You also need to take into account the tax advantages that are available on retirement investing, and given the fact that many employers match a portion of the employee contributions it makes sense to invest rather than reduce debt.
Conclusion
Knowing whether to reduce debt or invest will be dependent not only on the economic environment, but also on the state of your finances. The best way to tackle this is to have reasonable financial goals and to evaluate the investment options along with the risk tolerance and your current cash flow.