Are you better off using your savings to invest for the future or to focus on paying down debt? This is a tough question, and it depends on the kind of debt you have. Remember, your ultimate goal is to retire debt free by eliminating all mortgage, auto, credit card, and other loan payments. But before you can become completely debt free, you need to first tackle debt that has no immediate tax benefit and charges high-interest rates. Since auto, credit card, and personal loans match both of these criteria, they need to get paid off as soon as possible. As for mortgage loans and student loans, up to a certain amount, the interest paid is tax deductible. With that said, your effective interest rate is the rate you’re being charged on your loan multiplied by one minus your marginal tax rate. For example, if your mortgage interest rate is 6% and you’re in the 28% tax bracket, your effective interest rate on your mortgage is 4.3% (6% × (1 – 28%)). Knowing your effective interest rate is important when comparing the cost of debt and which loans should be paid off first.
But even with the tax benefits of a mortgage loan, it’s still debt that you should try to eliminate before retirement. So after you’ve paid off all your other debts (auto, credit card, student, and personal loans), it’s time to whittle this debt down to zero. The best way to get this done is by adding an extra $100 more to your mortgage payment. This approach not only reduces your outstanding principal/loan, but it will also reduce the amount of interest you pay over the life of the loan. For example, on a $250,000 loan with a 30-year term and a 6% interest rate, you’d pay $290,000 in interest for a grand total of $540,000. By making an extra $100 a month on this same loan, you’d cut the loan term by four and a half years and save $60,000 in interest. Just look at paying down your mortgage as a guaranteed return of 4.3% (6% × (1 – 28%)), which isn’t bad when you look at the returns we’ve seen over the past decade. And once you sell your completely paid-off house, you can use all that equity to pay cash for a smaller home in retirement and hopefully have some money left over to subsidize your nest egg.
If you’re open to making additional payments, maybe you can afford to make higher mortgage payments by taking out a 15-year loan when you refinance. A shorter mortgage term will not only save you interest expense but also allow you to pay your home off quicker. The only drawback with this approach is that you are locking yourself into higher payments versus allowing yourself some flexibility to make higher payments, as outlined above, on your terms. In the event you’re the kind of person who may choose not to add an extra amount to your monthly mortgage payment if it’s discretionary, locking in a 15-year mortgage where you have to make the higher payment may be your best option.
So when it comes to the question of “Do I pay down my debt or invest for my retirement?” you should pay down any debt that charges a higher-interest rate than what you can earn in the market. Based on the asset allocation models and the expected rates of return, any loan that carries an interest rate above 7% should be paid off first. Think of getting rid of this debt as earning a risk-free rate of return that also allows you to achieve your ultimate goal of saving for retirement. Since eliminating expensive debt that has no tax benefits is the best investment decision you can make, this should be your number one priority.
Another option for paying down debt that may be available to you is a home equity line of credit (HELOC). If you’re lucky enough to still have equity in your home and have a FICO/credit score of 700 or higher, you should be able to qualify for a HELOC. This product is just what it sounds like, a line of credit that you can access via a check, a special credit card, or other ways depending on the lender. Fees on HELOC loans are less than a standard mortgage, and you only pay interest on what you borrow against the line of credit. Since the interest paid is tax deductible, the effective interest rate you’re actually paying is a lot less than credit card or other personal loan debt. This may be a great option for you to get out from under any debt with interest rates higher than your effective rate on the HELOC. In addition, a HELOC could also be used as a source of retirement income where you can borrow against your home equity to cover retirement expenses.
Just remember that nothing is free, and you’ll need to pay this loan back either at a specified date in the future or when you sell the home. So make sure you have enough money to cover the loan and don’t start using the money to buy stuff you don’t need. Like I said, this isn’t free money, so don’t count on your house growing at 20% a year to bail you out as those days are long gone.
Note: When you’re looking to reduce your credit card debt, look for 0% interest rate offers from credit card companies for transferred balances. But before you make the switch, understand what the rate will be after the 0% teaser rate expires as well as any fees you may incur to transfer the outstanding balance. In addition, you may be required to stay with your new credit card company for a set time frame, which may eliminate any benefits you get up front once the teaser rate expires if you’re still carrying a balance.