Choosing whether to pay off some of your debt or invest some of your liquid assets in equities or other forms of securities is a complicated, yet necessary decision. It is common these days for most people to have accumulated a substantial amount of debt, and whether it is a credit card balance, a mortgage, college debt, a car loan, or other bills, you must weight the benefits of paying off these debts sooner with the benefits of investing your money to see which will give you the bigger bang for your buck over time.
There are many articles written about this topic and you may also refer to the Morningstar.com video below for extra guidelines, but this Solution will provide some tips and a Worksheet to get a quick start on this initiative.
Print the Worksheet from Slide 4, and for each of your debts, list whether the interest is variable or fixed, and whether it is tax-dedectible, and note the current interest rate. Keep in mind that if the rate is variable, it may be reasonable now (with rates near historic lows), but you can't assume that it will never increase.
Next, write down your current investment accounts, and indicate whether you're receiving any tax benefits by investing in that type of account and whether you are receiving a matching contribution on your 401(k) plan. Leave the Expected Return % column blank.
Next, use Morningstar.com's Instant X-Ray tool to identify the stock/bond/cash mix for each of your investment accounts. For each account, enter each of your holdings into the X-Ray tool, then click Show Instant X-Ray to see the Stock/Bond/Cash mix.
After finding the breakdown, calculate an estimated expected return for each account. Of course you can't be certain about the expected return for any asset class, so it pays to be conservative. We suggest a 2% return for cash, 4% for bonds, and 6% for stocks.
Now multiply these figures by the percentage (in decimal terms) of each asset class, summing the results for an expected return estimate. For example, a 10% cash, 50% bond, 40% stock, combination would be calculated as:
(2% x .10) + (4% x .50) + (6% x .40) = 4.6%
Fill these results into the Worksheet.
Now compare your potential investment returns with the interest you're paying on your debts and begin to priortize each item according to the following:
First Priority (tie): Debt with high interest rate relative to what your investments are apt to earn and interest is not deductible and/or you're paying private mortgage insurance.
First Priority (tie): 401(k) contributions that your employer is matching.
Second Priority: Debt with high interest rates relative to what your investments are apt to earn and interest is tax-deductible or debt with reasonable interest rates (4%-5%) and interest is not tax-deductible.
Third Priority (tie): Investments with reasonable expected rates of return (4%-5%) and that also enjoy tax-favored status (IRAs and 401(k)s).
Third Priority (tie): Debt with reasonable interest rates (4%-5%) and interest is tax-deductible.
Fourth Priority: Investments whose expected rates of return are in line with interest on debt and that enjoy no tax benefits.
Should you encounter a toss-up, prioritize the investment that offers the most certain return. In most cases, this will be a debt paydown with fixed interest or a fixed-income investment.