Many of us carry debt on our credit cards, car loans, mortgages, etc. But once you have your emergency funds saved up, the inevitable question arises:
Do you invest your savings or pay off your debt?
You’d definitely want to invest for your future, but also don’t want all your hard earned money to go to lenders in the form of interest payments and finance charges.
So you need to calculate whether you’re better off using your money to pay down your debt vs keeping the debt and using the money to invest instead.
You need to figure out whether you can earn a higher after-tax return on your investments than the after-tax interest rate expense on your debt? If so, you should invest. Otherwise, you’re better off paying your debt.
Let’s look at an example:
Let’s assume you have a 30 year $ 200,000 mortgage with a 7% interest rate. Let’s consider that you’re in the 25% tax bracket. Due to the tax-deduction on mortgage interest, your after-tax annual percentage is approximately 7% minus your tax rate, or 5.25% (7% – 7% x 0.25 = 5.25%).
This means that if you can earn an after-tax return on investment higher than 5.25% on your investments, you are better off investing.
If however, you’re carrying a balance on your credit card at 18%, almost no low-risk investment will generate that sort of returns. You’re much better off paying down your credit card balances, even if you have to use your emergency funds.
Except for rent or mortgage payments, there aren’t any emergency expenses that you can’t put on your credit card.
So if you have enough savings to cover a few months rent, you are usually better off using the remaining emergency funds to pay off your credit card debt.
You must exercise the self-discipline to re-establish your emergency fund before you go out and rack up your credit card bills again.
I know this sounds extremely obvious …
But if you carry too much debt and invest your money in illiquid investments or in investments that lose money you are then forced to file bankruptcy when emergencies occur.
Do you remember the day-traders in 1999 and 2000?
Some of them borrowed money out of their homes and lost it in the stock market. The last thing you want to do is over-leverage yourself and invest in high-risk investments.
If you lose your investments, you may end up losing your house …
How many of you think your spouses will stick around after you bet the house and lose it?