Got A Refund? Pay Off Debt First.
Many of us seek to invest at the same time that we pay off our debts. A failure to manage debt often hinders us in pursuing such major financial goals as saving for retirement or a down payment on a home. The following interest-rate management principles can help you to understand what's at stake:
Consumer debt offers no tax breaks. You cannot take a tax deduction for interest you pay on auto loans, credit cards, or other forms of consumer debt. Interest you pay on most mortgage and home equity debt, as well as on student loans, may be tax-deductible.
Tax-deductible interest lowers your effective interest rate of borrowing. To calculate, multiply the stated interest rate by a factor of 1 minus your income tax bracket. For example, if you are in the 25% tax bracket and pay 10% on a home equity loan, your effective rate is 7.5%.
Pay off higher-interest debt first. If you're using a debt repayment plan, pay off debt with the highest interest rate before all others. (Be sure to maintain scheduled debt payments on other borrowings, however.) Make a table of your debts, ranked in descending order by the effective interest rate. Here's a format you can use:
|Type of debt||Balance||Monthly|
|Credit card A||$2,000||$350||15.00%||15.00%|
Consider the opportunity cost of paying off debt. For example, say you have $5,000 and you're deciding whether to invest or repay debt. From the table, above, you see that you can pay your entire credit card balance, as well as pay down $3,000 of your auto loan.
If the opportunity cost of debt reduction is investing in a 6% CD, paying off debt is the better deal. You manage to wipe out $5,000 in debt that has an average combined interest rate of 12%. You should only consider investing if you can earn a rate of return of at least 12%.
Investing at a higher rate of return than your cost of borrowing is called leveraging. Leveraging can be risky. The rate of return you earn can drop unexpectedly, making your cost of borrowing higher than your return. Additionally, your borrowing costs may rise when your rate of return is unchanged.
Focus on after-tax returns when making the repay debt-or-invest decision. Unless you invest with a tax-deferred account, you will owe income taxes on your investments. You may even owe capital gains taxes. If you invest with a taxable account, be sure to calculate your after-tax return.
For example, if your pretax return is 8%, and you're in the 25% tax bracket, your effective rate of return is 6%. To decide between investing and repaying debt, compare the 6% return and the effective rate on your debts.