One of the common dilemmas of personal finance is whether a household should focus on paying down debt or saving money for the future. Unfortunately, there is no easy one-size-fits-all answer to this question but rather there are a number of factors that should be weighed.
The first factor to consider is the cost/benefit of each option. Benjamin Franklin wrote that “a penny saved is a penny earned.” In other words, the expected rate of return on an investment can be compared to the interest rate that will be applied to a debt. In a basic sense, money should be allocated to whichever is higher. However, this is not the whole story. The rate of return on an investment may be subject to risk while the interest charged on a debt may be steady. Therefore, the risk of the investment should be taken into account. In this case, a risky investment may need an expected rate of return that is above the interest rate charged on debt to make investing the better choice over paying off debt. In the case of high interest rate debt, where it will be unlikely that an investment will be able to outpace the interest rate charged, this can make the decision easy. In other cases, it may make the tradeoffs much closer so there is no easy answer.
Taxes should also be a major consideration. If money is invested for the future, what tax implications may that have. For example, if money can be put into tax-deferred retirement accounts, such as an IRA or a 401k type account, the potential lifetime tax savings may be a large benefit that favors investing over aggressively paying down debt. In addition, the interest on some debts may be tax deductible so that the taxpayer does not bear the full burden of the interest cost. In this case, the adjusted, or after-tax, interest rate should be used to compare the benefits of investing versus paying off debt. The taxation of the income used for each purpose should also be taken into consideration in order to avoid paying higher taxes than are necessary.
There may be other factors that should be weighed as well. For example, an employer may offer 401k matching funds. In this case, investing in a 401k may be more attractive than paying down even higher interest debt because the value of the savings match could be substantial.
The potential to refinance debt to a lower interest rate in the future may also be an important consideration. Debts that are high interest now but could be converted into lower interest rate debt within a reasonable time may be a less attractive candidate to be paid down when the cost of the debt will increase and financial resources can be used for longer-term goals.
The time horizons for goals are also important. For example, many longer-term investment strategies can have negative implications if the money is needed in the short-term. The investments could perform poorly in the short-term leading to a loss, retirement plans may be subject to a penalty if accessed before a certain age, or some investments have lockup periods. In these cases, it may be more beneficial to use funds to paydown debt, assuming the money can be borrowed again when needed in the future, so that the interest paid in the meantime will be reduced. In contrast, if money paid on a debt cannot be easily accessed in the future, such as paying down a low-interest rate mortgage which would require refinancing to a higher rate or borrowing through a higher interest home equity loan to access the funds, then investing, but in lower risk assets, may be the better option.
Clearly, with so many different factors to weigh, it is advisable to discuss options with a financial planner before deciding what strategy to implement. In addition, this is not an exhaustive list of the factors that should be weighed so the full costs and benefits of an action should be weighed before taking action, especially if the action cannot be easily undone.