Invest or Pay Down Debt?
Reader Question: “I have cash. I have debt. I want to invest. What should I do?”
Four different people asked me a similar question last week. Of course, in true financial planner style, I told each of them, “it depends on your individual situation.” My answer wasn’t intended to avoid the question, but to acknowledge two very important considerations: competing priorities and risk tolerance.
Anyone who is debt free will likely tell you, it “feels good” to not have debt. However, before you make extra payments to pay off your debt, let’s consider some of the other expenditures that you may need to make first; they are not in any particular order, because, that too, “depends.”
It is usually best to pay off the highest interest rate debt first, but not always. When interest rates rise (as many experts predict), variable and adjustable rate debt could get expensive. Let’s say you owe $100,000: half of it is a line of credit with a 3% variable rate and the other half is your 4% fixed rate home mortgage. While it may seem counter-intuitive, it would be good defense to pay off the variable debt, before making extra payments on the fixed rate mortgage. If interest rates jump quickly, that 3% variable rate could go to 5 or 6%!
What does risk tolerance have to do with paying off debt? Let’s assume you have addressed any competing priorities for cash. You have a $100,000 mortgage with a fixed interest rate of 5% for 30 years and you also have $100,000 in cash available to invest. Do you pay off the mortgage or invest? If you pay off the debt, you are eliminating 5% interest each year; logically, that’s the same as “earning” a guaranteed 5% each year. At today’s interest rates, a return of 5% or higher isn’t available − at least not without risk (which means it isn’t guaranteed). Using the $100,000 to pay off the mortgage can be a prudent move when you are uncomfortable putting the $100,000 at risk. On the other hand, if you are willing to accept the potential loss of some or all of the money, you could get a higher return by investing. Losses are often temporary in the market, as long as you stay diversified and have enough time to wait out a recovery.
Still not sure what to do? Try this test: Assume you have no debt and no investments, but you do have access to a $100,000 line of credit. Would you borrow the $100,000 and put it in the stock market? Be honest. If you wouldn’t, then put emphasis on paying down your debts before investing.
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.