Whether it’s student loans or medical debt, many people wonder if they should focus on paying back their loans or investing for retirement. Typically, these people don’t intend on ignoring their loan payments. Rather, they have extra money and are debating whether they should use the extra cash to accelerate their loan payments, or if that extra cash would serve them better in a retirement fund.
After all, people in debt want to avoid debt in the future and are often thinking about strategic moves to better their financial situation. However, the distinction between investing and paying off a loan isn’t always a clear one. Sometimes the choice is clear. For instance, if bankruptcy were an eminent threat, paying back loans would be the wiser option. But what if you have extra cash and an employer matches your contributions? Then the decision can become a little blurrier.
Paying Back Loans is the Best Investment
The best advice is to consider accelerating your loan payment as an investment opportunity. Think of it this way: You are paying off debt now so that you can have money in the future. Typically, the interest building on debts will outweigh the credit you would gain from an investment. Furthermore, even if investments sound good at first, you must also consider how much interest you actually earn after tax is taken into account. For instance, a “5 percent bond” really only accrues 3.6 percent after taxes.
In short, when considering the difference between paying back loans and investing, consider the rate of interest you are paying for your debt after tax and compare it to the interest that you would earn from an investment after tax. Remember that there are two kinds of debt:
1. High interest debt. Debt collected on a credit card is most difficult to manage. In fact, credit card debt is one of the most significant causes of bankruptcy.
2. Low interest debt. Student loans and medical bills have much lower interest rates than credit cards. While bankruptcy could still be a threat, the debt is typically more manageable.
Considering which category your debt falls into can help you determine whether to accelerate your loan payments or invest. It would certainly be easier to invest as long as the debt was low interest.
What About “Free” Money?
If you aren’t in danger of bankruptcy and have low interest debt, it might be worth considering making an investment with extra cash. One of the most tantalizing dilemmas is if your employer offers matching contributions to retirement accounts. After all, it would seem foolish to leave “free” money on the table. Remember, that matching contributions are akin to a 50 or even 100 percent immediate return on your investment – on top of the interest that will accrue over the years!
However, unless you’re missing out on a 401k opportunity such as a matching contribution scenario, the general best option would be to pay off loans that can increase the value that you owe – and thus lose – over time.