The very common question that comes to an individual’s mind is best to pay debt first or invest in whoever has debt.
The basic thing is that there are many types of investment options and debts out there in the market to consider.
However, it is suggested that individuals should pay debt first before investing money in any type of investment scheme. Below are a few tips to answer this question.
Most important if you have credit card debt pay it first before you start investing. The reason behind this is credit card debt cost may increase at some time and the debt burden can increase which results in the loss of your investment.
Suppose you have any type of fixed-income investment like bonds, or fixed deposits, you should sell that bond and liquidate a fixed deposit to pay the debt because the returns on the given investment might be less than the cost of the debt.
It is recommended to pay the debt before investing because debt can stop you to take a risk in the equity funds.
Risk Premium: Reasons to Pay Debt First
The returns which you will get from the risk-free investment are less than the cost of the debt except for a few investments like stocks but it is also not granted to give you higher returns. The risk premium is also known as higher expected. Risk premium defines the risk taken by you and the reflection of the degree of the risk.
Some of the longer-term bonds are given a risk premium of around 2% a year above the return of one-month T-bills. This is what is known as term risk and in most cases, it is related to inflation.
On the other hand, stocks have earned approx 7% of risk premium a year. Small risker and value stocks also earned risk premiums.
Let’s assume a scenario, where the T-bills are at 4%, and stocks are expected to return at 10% and the risk premium of 6%. And in case your debt costs you 8% then the risk premium can be only 2%. Now you are taking a risk of 6% and earning only 2% which does not make sense to invest before paying the debt.
Now it could look more complex because you have to look at after-tax returns. Therefore, you need to adjust the cost of the debt to look like true after-tax cost and also need to adjust equity returns to look the capital gain lower in case taxable account.
Investing where Tax Exempted
Investing the accounts like PPF, NPS, and other government-sponsored saving schemes can save tax or are allowed for tax exemption. Now the question is whether investing in these accounts and schemes will give more retunes and whether it is advisable to invest before paying the debt. The answer is doing the math and calculating the amount of the returns after tax and comparing it with the debt cost.
Now, this is important that most of the people with mortgages don’t qualify for the mortgage deduction because they use the standard deduction or because of alternative minimum tax. It is also important you should pay your debt in a riskless transaction, except if the fixed investment is backed by the government. You may get high retunes after paying the credit card debt.
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The Mortgage is Debt like Other Debt
The mortgage is debt too like other debt. Most people make mistakes while asset allocation they don’t think about the mortgage on their home as debt. Mortgage debt must be considered as other debt and people should not leave a mortgage without paying because it affects their returns on investment.
Mortgage vs. Investing
Suppose your financial plan allows you to earn high returns on your investment without paying the mortgage you can start investing. But in case you get fewer retunes on your investment you should be ready to take the risk.
Figure out the asset allocation carefully to get good returns on your investment and find a way to pay the mortgage. Sometimes it does not give a big effect on your investment returns because the cost could very less on mortgage debt.
The Final Word!
It is recommended to pay any debt including a mortgage before investing because debt cannot let you take a risk on funds like equity.
Sometimes it is good to invest without paying the debt, in that case, do the math and deep research to consider one of the options which can benefit you.