Should You Pay Down Debt or Invest?

"If I have a mortgage, am I better off paying it down as soon as I possibly can, or should I use that money to invest in the market instead?"

One of my neighbors asked me that question, and I instantly knew that the topic would strike a chord with Morningstar.com readers.

The shelves of your local bookstore are full of tomes that coach consumers on how to get the credit card monkey off their backs, and there's universal agreement that if you're carrying a balance on your credit card, the best thing that you can possibly do is get rid of it as soon as possible. The mortgage crisis also provided countless examples that taking on more mortgage-related debt than you can afford is a ticket to financial ruin.

But other types of debt, such as a manageable mortgage and low-interest student loans, occupy an underanalyzed middle ground. Interest rates on these types of debt are often substantially lower than credit card rates, and that interest may, in some cases, be tax-deductible. For those reasons, it's worth analyzing whether the aggressive paydown of that debt is the best use of your money or whether you should invest in the market.

Ultimately, it's a truly personal decision that's affected as much by your own personality as it is by math. I know several financially savvy individuals, including some of my Morningstar colleagues, who prioritized paying down their mortgages (or even paid them off altogether) over putting even more money into their investments. They wanted to reduce their households' fixed costs, and they've told me that step helped buy them peace of mind and gave them greater flexibility. Other people, particularly those who are just starting out and want to take maximum advantage of the compounding that long-term investing affords, may choose to invest in the market rather than prepaying their mortgages on an aggressive schedule.

Here are some of the key factors that affect the decision about whether to pay off debt or to invest. Some of these variables, as you'll see, are difficult to quantify with precision.

Anticipated Return on Investment. You might think you can easily out-earn your mortgage interest rate, particularly given how low interest rates have gone over the past few years. However, bear in mind that paying off your mortgage offers a knowable rate of return (assuming it's a fixed-rate loan), whereas investing in almost anything else does not. Even if you're investing in a CD that pays you a fixed rate of interest, you may have to settle for a different, lower rate in the future. (And in any case, CD rates are currently below mortgage rates.)

Your time horizon for your investments will also likely have a significant impact on the combination of investments you choose and that, in turn, will affect the rate of return that you're able to earn. If you're a younger investor with a long anticipated time in the market and a high percentage of your portfolio in stocks, which have historically garnered better returns than bonds and cash, you could make a stronger case for paying less on your mortgage while putting more money into the stock market. Because of compounding, a dollar saved today is worth substantially more than one saved 20 years from now. Moreover, the larger your portfolio's equity stake, the more likely you are to be able to earn back your borrowing costs. (There are no guarantees, though. While stocks have returned more than bonds over very long periods, there's no telling whether that will be the case in the future.)

If, on the other hand, you have a big percentage of your portfolio in bonds because you hope to retire within the next 15 years, you have a smaller chance of recouping your borrowing costs and should think about paying down your mortgage on a more aggressive schedule.

Interest Rate to Service Your Debt. This factor seems straightforward, right? Yes, if you have a fixed-rate loan. But if you have an adjustable-rate loan, calculating your borrowing costs is more complicated. Adjustable-rate mortgages typically fluctuate in line with prevailing market interest rates, which makes it tricky to forecast long-term borrowing costs. While interest rates are currently quite low relative to historic norms, which in turn benefits borrowers with variable-rate loans, that may not always be the case.

Number of Years until Retirement. One of the best things pre-retirees can do is to reduce their fixed costs going into retirement. Doing so buys them more flexibility and reduces the income they'll need to take from their portfolios once they retire. That, in turn, improves the odds that their portfolios will last throughout their lives. So if you're getting close to retirement, reducing or eliminating debt should top your list of priorities.

Tax Benefits Associated with Your Debt. Credit card debt has been rightly demonized as having no redeeming qualities whatsoever--unless you're the credit card issuer, that is. But other types of debt may receive tax breaks that can help reduce your overall borrowing costs. For example, you're typically able to deduct any mortgage interest, as well as the interest on some types of home equity loans, on your tax return. This can be a particularly big advantage early in the life of your mortgage, when most of your payments go toward interest expenses. Say that your annual mortgage interest outlay is $20,000. If you're deducting that interest, your real mortgage cost is substantially lower.

You can also deduct student loan interest payments, up to a certain amount, provided your income falls below a certain threshold and you meet other requirements.

However, it's worth noting that taxpayers have a choice of either itemizing deductions or claiming a standard deduction on their income tax forms; in 2011 the standard deduction for single filers is $5,800, and $11,600 for married couples filing jointly. If your itemized deductions aren't substantially higher than your standard deduction, your tax savings from interest-payment deductions may not amount to much.

Tax Advantages Associated with Investing. Just as certain types of debt are tax-deductible, you're also able to take advantage of tax breaks when you sock away money for retirement and college in certain types of vehicles. Those tax breaks can add to the return that you're able to pocket from those investments. Savers in 401(k)s and traditional IRAs enjoy tax-deferred compounding, while investors in Roth IRAs and 529 plans enjoy tax-free withdrawals when they use the money to pay for retirement and college, respectively. Therefore, the actual returns that you earn by saving in these types of vehicles are higher than what you earn on taxable investments.

Matching Contributions. Some employers match a portion of employees' contributions to their company retirement plans. That obviously enhances the attractiveness of investing at least enough to earn any matching funds that your employer has promised.

Private Mortgage Insurance. Private mortgage insurance is another factor to consider when deciding whether to invest in the market or to pay down your mortgage. Lenders typically require you to pay for this insurance if you have less than 20% equity in your home. Thus, if you're on the hook for PMI, you have a strong incentive to get rid of it as soon as you possibly can, either by paying down your principal value aggressively (and thereby building up your equity in the home) or by having your home reappraised if you've made substantial improvements to it.

Those are the general guidelines to bear in mind when you make your household's capital allocations. If you'd like to take a closer look at which financial payouts will give you a greater bang for your buck, take the following steps.

Step 1: Using the Expected Return Worksheet, write down any debts you have outstanding, including mortgages, home equity loans or lines of credit (if you currently have a balance), student loans, or credit cards. Fill in the Interest Rate % column; indicate if your rate is variable.

Note whether any part of that interest is tax-deductible. Also take note of whether you're paying private mortgage insurance on your home loan.

Step 2: Now write down your current investment accounts. Indicate whether you're receiving any tax benefits by investing in that type of account, as well as whether you're earning any matching contributions. Leave the Expected Return % column blank.

Step 3: Use Morningstar's Instant X-Ray tool to identify the stock/bond/cash mix for each of your investment accounts: 401(k)s, IRAs, and any taxable accounts. Start by entering each of your holdings into the tool, then click "Show Instant X-Ray" to see the stock/bond/cash mix (also called an asset allocation) for that account.

Step 4: After you've found a stock/bond/cash breakdown for each of your accounts, calculate an expected return for each one. Of course, you can't be certain about the expected returns of any asset class, but a reasonable starting point is 1% for cash, 3% for bonds, and 6% for stock holdings.

If your account consists of some combination of stocks, bonds, and cash, you'll need to come up with a combined expected return. For example, if Instant X-Ray says that your account consists of 10% cash, 50% bonds, and 40% stock, you'd calculate the expected return as follows: a 2.4% return from the stock portion of your portfolio (6% times 0.40), a 1.5% return from the bond portion of your portfolio (3% times 0.50), and 0.1% contribution from the cash portion of your portfolio (1% times 0.10). The aggregate expected return for such a portfolio would be 4.0%. (2.4% + 1.5% + 0.1%)

Step 5: Compare the potential rates of return for your investment assets with the interest that you're paying to service your debt. Prioritize your spending in the following sequence:

First priority (tie): Debt with high interest rate relative to what your investments are apt to earn, where interest is not deductible and/or you're paying private mortgage insurance

First priority (tie): Company retirement-plan contributions that your employer is matching

Second priority: Debt with high interest rates relative to what your investments are apt to earn, where interest is tax-deductible--or, debt with reasonable interest rates (4% to 5%), where interest is not tax-deductible

Third priority (tie): Investments with reasonable expected rates of return (4% to 5%) that also enjoy tax-favored status--IRAs and 401(k)s

Third priority (tie): Debt with reasonable interest rates (4% to 5%) and tax-deductible interest

Fourth priority: Investments whose expected rates of return are in line with interest on debt and that enjoy no tax benefits.

As you go through this exercise, you're almost certain to encounter one or two toss-ups. When you do, the tie should go to the investment that offers you the most certain return. For example, say your mortgage interest is 5% and you're forecasting a similar return on your IRA. Because the return on your mortgage paydown is certain, whereas your investment's return is not, it makes sense to prepay at least some of your mortgage each month before putting cash to work in the IRA.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar Inc.

See More Articles by Christine Benz

		New! 30-Minute Money Solutions
	Need help picking up the pieces in this turbulent market? 30-Minute Money Solutions by Morningstar director of personal finance Christine Benz simplifies the daunting task of getting your financial house in order. Written for novice and experienced investors alike, this book offers manageable, step-by-step solutions for tackling money challenges and building a comprehensive financial plan in simple 30-minute increments. Learn more.
	Order Your Copy Today--$16.95