If you receive a windfall of cash (such as a tax refund or collection of a debt from a friend), you may face a common dilemma: Invest, pay off debt, or spend. (Spending is not considered as an option here.) If better personal budgeting has helped you save an additional amount every month, a debt repayment plan may be preferable to saving until most of the debt is gone.
Generally, paying off or paying down a debt that has a higher interest rate is preferable to making an investment that earns a lower interest rate or rate of return. To make a fair comparison, you need to calculate the after-tax interest rate on your debt and nvestments. If your investment is not held in an interest-earning account (such as a money market or savings account, CD, or money market mutual fund), calculate the investment's after-tax return.
If you are paying off a credit card or auto loan, you can use the APR as the effective interest rate if available, or use the stated interest rate for sake of simplicity. If you are paying off a mortgage, home equity loan, or student loan, start by subtracting your income tax bracket from 1.0.
For example, if you are in the 25% tax bracket for 2008, you would have 0.75 (1.0-0.25). Then, multiply 0.75 by the loan interest rate. The result is your after-tax interest rate on tax-deductible debt. If you have a mortgage loan of 8% and are in the 25% tax bracket, your after-tax interest rate is 6%.
If you plan to invest in a stock, bond, or mutual fund that invests in any of these types of securities, you should have an idea of the investment's expected return. For example, if you invest in a mutual fund that earns an annual rate of return of 10%, you may decide to use that return as our expected return. Use the same calculation rule to calculate the after-tax return on investment (which is based on expected return).
You should calculate the after-tax interest rate or return for investments held in taxable accounts. For example, if a taxable investment earns a 10% return and you are in the 25% tax bracket, your after-tax return is 7.5% [(1.0-0.25)*.10]. (Investments in tax-advantaged accounts are not taxed until you begin to take money out, which generally occurs after you retire. If using a tax-advantaged account, the interest rate earned on the account is equal to the after-tax rate to keep things simpler.)
In most cases, the APR on your credit card debt or an auto loan is higher than the after-tax interest rate or after-tax return on an investment. These types of consumer debts, particularly credit card debt, since it is unsecured credit, are among the most expensive. As a result, paying off a credit card is almost always a better deal than investing. While some investors use their credit cards to raise funds for speculative investing, this kind of leveraging is an extremely risky practice and should be avoided.
Paying off debt is sometimes a painful experience. Not only do you miss a chance to spend, you also pass opportunities to save or invest. However, if you've improved your budgeting efforts and have been able to save extra money, you will improve your personal cash flow further by paying off high-interest debt. The basic relationship pay off debt that has a higher interest rate than what you earn on your investments is a practical step in the right direction.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.