Pay off debt or invest?

Rachel Haig  |  19/04/2012Text size  Decrease  Increase  |  

Rachel Haig: I'm Rachel Haig from Morningstar.com. A big question for a lot of investors is what is the best way to use their money? If they don't have enough to do both, does it make more sense to invest or to pay off debt? Here with me to address some of these issues is Morningstar's director of personal finance, Christine Benz. Thanks for joining me, Christine.

Christine Benz: Rachel, nice to be here.

Haig: So, where should someone start if they're grappling with this decision?

Benz: One obvious starting point is if you have high-interest credit card debt. In that case, it's very unlikely that you'll earn 18% or 20% by investing in the market, so paying off that credit card debt is going to be, by far, the best return on your capital.

One other area would be setting up an emergency fund, because the worst thing would be to find yourself digging an even bigger hole by layering on more credit card debt while you're paying off additional credit card debt. So you want to carve out that emergency fund, usually three to six months worth of living expenses.

And finally, if you're earning a 401(k) match, not investing in the 401K plan is the equivalent of turning away free money.

So those should be three starting points for anyone who's wrestling with the question of whether to pay off debt or invest.

Haig: When you're looking at which type of debt you should pay off first, obviously high-interest credit card debt, where you're paying a lot and not getting anything for that, is one of the first things you should eliminate. But how should you calculate it, generally? Which sort of debt is worth carrying?

Benz: Other types of debt, like mortgage debt and student loans, sometimes are characterized as good debt. But realistically, I think you have to think about whether you could earn the rate of return by investing in the market that you're paying to service your mortgage loan, or even your student loan. So even though those rates might seem nice and low on paper, paying them off or prepaying them is a sure return on your money.

Another consideration to bear in mind is whether you're earning any sort of tax deduction on your interest. If you are earning a tax reduction on your mortgage interest or on your student loan interest, that may push them down a little further on the priority scale versus investing.

Haig: OK. And what impact would it have if someone's carrying private mortgage insurance? Does that play into this at all?

Benz: It's definitely a consideration. Typically, you have to pay private mortgage insurance if you have less than 20% equity in your property. So if you are someone who's on the hook for PMI, that would encourage you to prepay the mortgage on a more aggressive schedule than perhaps your mortgage lender requires you to do. That would be another argument for definitely paying an extra $100, $200 a month to get rid of that PMI as soon as you possibly can.

Haig: All right. And what about for people who are younger or people who are further along in their investing careers? How does that factor into their decision?

Benz: Your portfolio's stock-bond mix should definitely figure into the decision. One way to think about it is, what return am I likely to earn on this portfolio? If I'm someone who's later in life and my portfolio is consisting mainly of bonds and cash, realistically, my return on that portfolio may not be that high, and I may well be better off paying down my mortgage or paying whatever debt I have off versus investing additionally in that investment portfolio.

So asset allocation is definitely a consideration. Someone who is earlier in life, and maybe their portfolio is predominantly stocks, that's a greater argument for investing in the portfolio versus paying down, say, mortgage debt.

Haig: Well, those sound like great guidelines. Thanks for joining us today.

Benz: Thanks, Rachel.

Haig: For Morningstar.com, I'm Rachel Haig.

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