Pay off Debt or Invest: How do you Decide?

It’s one of the classic personal finance issues: do you invest or pay down debt?  People often answer the question: it depends on the numbers, which is true.  Pay off debt at 20% on a credit card will crush likely most investments, but if your mortgage is at 4% and your investments usually get 6%, the math gets a little complex.

The major issue if to really compare you options you need to make them equal.  Trying to compare just straight percentages is stupid, since you often need to consider if that money after tax or before tax.  If it is taxed, then how it it taxed: dividends are much cheaper than interest.  I’m not saying the math isn’t difficult at times, but really it varies so much from situation to situation that you really need to do it yourself and find out what works on paper.

Then we have to evaluate the more fuzzy issues like risk.  A extra mortgage payment grants you a after tax return equal to your interest rate at no risk.  Stocks on the other hand have a lot more risk, so you have to weigh those issues.  How you do it will vary from person to person.  I tend to keep in mind the fact you need to balance all your investments for risk.  So if you are fairly heavy into high risk investments and you get some extra cash, consider a lower risk option for that extra money.  You don’t want to be too conservative or risky, but rather balanced on the overall picture.

Then last, but most important, you need to consider your personality.  Often decisions we make are not logical, but rather emotional.  You may know the math says you are likely better off investing, but you really still want to pay off the mortgage early?  It’s ok to pick the mortgage.  Not even decision in life must be optimized for maximum return.  The point is are you paying off debt and investing regularly? Yes, great you are ahead of most people in the world.  So don’t panic about trying to do everything right.  Remember to do what works for you.  There is no point investing if you are mentally not really for the risk.  The sleep at night factor is worth something so don’t sell our yourself out for a 1% extra return if you don’t think you will handle it well.

4 thoughts on “Pay off Debt or Invest: How do you Decide?”

  1. The issue of how one handles stock market risk is very important. It seems to me that one cannot answer that question without first having some actual experience in the market when it drops.

    When a mutual fund retailer (bank etc)asks a client how much risk the client wants to take it is really a misleading exercise. Most people are not qualified to answer that question. Only those who have lost money in the market have any idea what “their answer should be”.

    After the recent market drop many more people can now answer that question with a more valid answer.

  2. The other question that needs to be asked is the type of debt; is the interest on the debt tax deductible or non-tax deductible. If you can write off the interest on the debt that in essence lowers the comparative interest rate.

  3. I only consider it debt if I can’t actually pay it off (ie.- a mortgage that I can’t turn around and pay off tomorrow or it’s not earning enough to pay for itself). So debt on a rental property is fine, as long as the propery brings in enough to pay for itself. Especially since that interest is tax-deductible. Debt on a car or credit card isn’t as far as I’m concerned.

  4. My idea is I’m going to max out my RRSP each year, and take the refund to pay down my mortgage. I’m only 30, so I have time to allow the RRSP to grow, and using the tax rebate to pay down the mortgage will be a nice way to get a win-win situation.

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