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Investing Vs. Paying Off Debt Early

Which should you do first?

This is an age-old question and has been asked hundreds of times to advisors and I’m sure you will you will find that the answers vary depending on who you ask. I am here to give you the one and only answer to this question which is……..It depends. I know this may not be the answer you were looking for but let’s take a holistic approach to this question as I do with all personal finance advice. As you know, everyone’s situation is different so what might be great advice for one person might be not so great for the next individual. With this being said, I will do my best to answer the question for specific situations and let you decide where you fall.

First let’s define the various types of debt and I will place them in 3 separate categories; Good Debt, Fair Debt, and Bad Debt.

  1. Good Debt. I define good debt as any debt that someone else is paying for. I developed this concept from the famous book “Rich Dad Poor Dad” by Robert Kiyosaki. An example of this type of debt is rental property. If you have a loan on a rental property odds are that the tenants are paying the loan and hopefully you are taking some profit off the top. I would not recommend paying off this debt early since it’s really not your debt to pay since someone is paying it for you.
  2. Fair Debt. I define fair debt as debt that has tax advantages on the interest that you paid. An example of this type of debt is student loan debt and mortgage debt on your personal home. As stated before, this debt has tax advantages on the interest you pay which is up to a $2,500 deduction on student loan interest paid and fully deductible mortgage loan interest. On top of the tax advantages, these loans typically have low interest rates (assuming fair credit score). Student loan APR ranges from 4-7% and mortgage loans tend to range from 3-6%. After you input the tax deduction you are looking at about 4% and 3% APR respectively (Loan APR * (1-tax rate)).
  3. Bad Debt. I define bad debt as just about all other debt not mentioned above. This means credit card debt, car loan debt, personal loan debt, etc. These debts usually carry high APR’s and no tax advantages.

Now that we have defined the various types of debt lets answer the question. Which debts should you pay off early and which debts should you pay the minimum requirement and invest the rest? Let’s take it from the top, when it comes to “Good debt” I would not recommend paying this off early. As stated before, someone else is paying for this debt and you will be better off reinvesting the profits made from this debt to build more wealth. Now for “Fair debt”, This is where is gets a bit complicated. Some advisors see benefits in paying your mortgage off early, whereas others believe there is no reason to pay off your mortgage early because you will get a better return in the market. I say, it depends on who you are and your values as a person. If being completely debt free as quickly as possible is a high goal of yours then go for it! You will get around a 3% guaranteed return on your money which is beating inflation and you are more quickly owning an asset that will likely appreciate. When it comes to student loans, it depends on factors like; loan amount, APR, and loan duration but typically I advise that if you pay more than $2,500 in interest each year feel free to put extra money toward your student loans before investing. Lastly for “Bad debt”, I ALWAYS recommend my clients use any extra funds to pay this debt down asap! These debts usually have double digit interest rates and can take years to pay off otherwise. For example, if you pay an extra $1,000 toward your credit card debt that has a 20% APR you are essentially getting a guaranteed 20% return on you investment! Try getting that in the market.

Bonus note: I recommend all clients invest in their 401k up to the company match prior to paying any debt down early. The money given to you in a company match 401k program is FREE MONEY. Essentially you are getting an infinite return on your investment and I don’t think anyone should miss out on this free money.

In conclusion, the answer to this question is client specific and should be answered only after viewing your entire financial picture. I hope found this blog helpful and please subscribe for more content!

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