How to Decide Whether to Invest or Pay Off Debt

When you come into unexpected money, you might be faced with the decision of if you should use it to pay off existing debt or invest it. If you are just making it by each month, your first thought might be that it would make the most sense to pay off some debt and lower you monthly expenses. However, in some cases, investing it could be the wiser choice.

Instructions

Difficulty: Moderate

1. Make a list of all of your existing debt. Be sure to include the nature of the debt, the total amount that you owe, the interest rate that you are being charged, and the dollar amount of the interest portion of the debt each month.
2. Factor in any tax benefits of your debt. To be sure that you are comparing apples to apples, you have to figure your debt after taxes. For example, if your mortgage carries a 6% interest rate and you pay a 35% income tax rate, the after tax cost of your mortgage debt is really only 3.9%. Credit card debt, on the other hand, unless it is used in a small business, is not tax deductible, so use the full amount for your comparison.
3. Investigate your invest options to see the annual rate of return. Then compare the interest amount that you would receive off the investment to the interest amounts that you are paying on each of your debts. Again you have to consider taxes. In most cases you need to pay taxes on the money made from the investment, lowering your actual profit.
4. Consider the level of risk involved. Paying off your existing debt carries no risk. Investing, however, comes with a certain amount of risk. The risk level varies depending on the type of investing you are considering. Low risk investing such as savings accounts and CDs are most likely not paying as much interest as you would save by paying off debt. Higher risk investing might yield more of a profit that paying off debt, but the risk level involved means that it also might not; and in some cases you could loose your money together.
5. Use a financial calculator to help yourself further decide if paying off debt or investing makes the most sense. There are several financial calculators on the Internet available for you to download free of charge.
6. Pay off the debt that carries the highest, after tax, interest rate if you decide not to invest the money.