The decision between paying off debt vs. investing to accumulate wealth is largely personal. Some people hate having any debt and may be inclined to pay off all debt before contributing to an investment account where as others are confident that their return on investment will make up for the interest on their debt.
Below are factors I take into account when I decide whether to send my army of little workers (money) off to kill debt or to make more of their own.
1. At what level of interest do I choose to invest over paying down debt?
Generally speaking I am an index fund believer so I estimate my average return to be equal to that of the stock market (~9% average historic return), since I max out my tax sheltered accounts already, I base my current decision to invest on the additional taxes that I could get hit with in a regular investment account.
Generally speaking, if the debt is less than 6% I prefer to invest in place of paying down the debt.
2. What is the interest rate for my debts?
Next, I look at what the interest rates are on my individual debts.
a. Credit Cards have the highest debt so I always pay them off the full balance every month.
b. My mortgages ( I have two, a condo from residency that is finally no longer underwater and my current home). I bought on a variable arm for my condo, the rate is low now, but I am weary of the rates going up, I waiver on whether or not to pay it off. My current home has a 3.75% rate so I am less inclined to pay it off at this time.
c. Student Loans, I am lucky because I have paid down most of my student loan debt (and also paid for a large amount of school with scholarships). My only student loan debt is a low 1.75%, talk about lucky timing. So I have elected to hold off on additional payments. The downside to having this debt is that I cannot right it off because of income phaseouts. If my rate was higher, I would be working on killing this debt. For now I will let it sit.
3. Debt reduction as a means of diversification
Given the interest rates on my current debt I am more likely to get a better return on the market than the guaranteed tax free return of paying off debt and avoiding interest. Therefore, I have elected to focus most of my contributions to the market.
However, I also think of debt reduction as a means of diversification because I essentially have a guaranteed return and a home can act as a hedge against the market. It is probably a better guaranteed rate compared to buying a bond fund in my taxable accounts. Markets can always crash, whereas paying off debt is equivalent to a guaranteed return. Therefore, I continue to make the occasional additional payment to both my house and condo.
So what would you do? Comment below.