If you spend more money than you make, you are in debt. When the federal government spends more money than it collects, it is in debt. It really is that simple.
But let’s put it in historical perspective – the US has not been debt free since 1835, when President Andrew Jackson decided to pay off the $75 million debt of all the states by selling land in the western part of the US and blocking every spending bill he could. So, on January 8, 1835, the US was debt free.
It lasted just one year.
Reducing your debt burden is vital to you financial well-being. But which comes first, paying off the debt or saving and investing? In some cases, it is best not to wait until you are out of debt to start putting your money to work.
To decide whether to pay down debt or invest, look at the interest rates you pay and consider whether you could earn a higher after-tax rate of return on the investments than the after-tax interest rate on the debt.
For example, say you have a credit card with a $10,000 balance on which you pay nondeductible interest of 18%. In this case, it’s probably best to pay off the debt because your chances of making an after-tax rate of return greater than 18% are very slim.
On the other hand, let’s say you have a mortgage with a $10,000 balance and you pay deductible interest of 6%. If your income tax rate is 28%, your after-tax cost for the mortgage is only 4.32% ((6% x (1 - 28%). You would generally need to earn an after-tax rate of return greater than 4.32% to consider making an investment rather than paying off the debt. If the outlook for earning an after-tax rate of return greater than 4.32% is good, it may be better to invest the $10,000.
Of course, it isn't an all-or-nothing choice. You can pay off debts with high interest rates first, and then invest when it makes more sense than paying off debt. Let’s say you have a $10,000 balance on your card at 18% nondeductible interest and you owe $10,000 on your mortgage at a deductible interest rate of 6%, and your tax rate is 28%. In this case, you should pay off the credit card first.
When investing, keep in mind that the higher the rate of return, the greater the risk, which can include the loss of principal. If you make investments rather than pay off debt and your investments incur losses, you may still have debts to pay, but will you have the money needed to pay them?
When deciding whether to pay down debt or to save and invest, consider the following:
Reducing your debt burden is a critical component to your well-being – that is indisputable. But eliminating debt completely without saving and investing might not be the best course of action for you and your family.
Give me a call and I can run different scenarios for you in order to help determine how to proceed.