Should You Invest or Pay off Debt?

When deciding whether to pay off debt or invest, a good first step is to compare the interest rate you're paying on your debts to what you would earn by saving your money. However, if you were to receive a raise of, say, $100 a month, deciding what you should do with it isn't always so straightforward. Here are some ideas to help you to determine what makes sense for you.

Retirement savings plans
If your employer offers a retirement savings plan -- such as a 401(k) -- that matches a portion of what you contribute, it's almost always in your best interest to take advantage of it. If the company tops up your contributions by 50 percent, for example, your $100 a month will suddenly transform into $150, not to mention the tax savings and compound interest. Never say no to free money!

Credit-card debt
Your decision is also easy if your company has no such plan (or if you're already contributing the maximum) and you have credit card debt with a very high interest rate. Say your card has a balance of $2,000 at 18 percent and you are currently paying $50 a month. At that rate, it will take more than five years to retire the debt and you'll pay a whopping $1,077 in interest. Up your payment to $150 and the existing debt is gone in 15 months with just $248 in interest. That's a far better choice than putting the money in a fixed-interest savings plan.

Interest rates
Many financial institutions now offer high-yield savings accounts with rates that are higher than some loans. You may have a student loan, for example, that you're paying back at 3.5 percent. It makes little sense to accelerate your payments on this loan if you can put your extra $100 a month into a savings account, CD or other investment with a guaranteed return of over 4 percent. (A financial advisor may also be able to recommend stocks and/or equity mutual funds that may provide you with a potentially higher long-term return but which carry the risk they could go down in value.)

Mortgages
But what about paying off your mortgage faster? If the rate on your investment is lower than that of your mortgage, wouldn't it be better to pay off your home loan faster? Not necessarily. Here's an illustration that assumes your mortgage is $150,000 at 5.5 percent, amortized over 25 years:

Option 1
You use your $100 a month to make an annual prepayment of $1,200 in each of the next five years. Doing so would reduce the interest on your mortgage during that period from $39,789 to $39,073, for a savings of $712.

Option 2
You put $100 a month into a high-yield savings account earning 4.5 percent. After five years, you will have earned $740 in interest -- more than you would have saved on your mortgage. (The difference is due to the power of compounding.) Best of all, you'll have a nest egg of more than $6,700.

Income tax
There are two other factors to consider. The first is income tax -- if you deduct mortgage interest on your returns, the amount you save by making prepayments is reduced. In our above example, if your marginal tax rate is 25 percent, your 5.5 percent mortgage really only costs you 4.125 percent after deductions. By the same token, you pay tax on interest you earn through most investments, so, in this example, your net return on a 4.5 percent account would really be 3.375 percent. These taxes may cancel each other out, but if you do not deduct mortgage interest, or if you're saving your money in an investment that defers tax (such as retirement account), this may sway your decision. Ask a tax adviser for advice on your particular situation.

The other factor you should not ignore - especially when the decision is a close call, as in our above example-- is your own comfort level. If you're nervous about being in debt, you may be better off buying peace of mind by paying it down, regardless of your investment opportunities.