Should You Repay Debts or Invest?

© Paula Pant

One of the toughest questions in personal finance is: Should I repay my debts, or invest the money?

If you have high-interest debt such as credit card debt, this choice is clear: you should repay that loan immediately.

Many credit cards have double-digit interest rates, which means you're paying an interest rate that's substantially higher than the amount you'd earn in an investment with reasonable risk.

But what if you only have low-interest loans, such as a mortgage? Should you repay that loan as quickly as you can? Or should you put that money towards investments, such as making additional contributions to a retirement account?

Here are a few factors to consider.

(This article starts with the assumption that your only debt(s) are low-interest loans, such as a mortgage with a reasonable interest rate.)

#1: Do You Have an Emergency Fund?

If you don't have an emergency fund, this entire question is moot. Your first priority is to build a rainy-day fund, which should represent three to six months of your income.

This is the money that you'll fall back upon when life throws curveballs your way. If you get laid off from work at the same time that you need to pay medical bills, for instance, your e-fund will carry you through.

#2: Are You Claiming Your Employer Match?

If you're eligible for an employer match in any of your retirement accounts, are you collecting the full match?

For example, if your employer will match your 401k contributions up to 3 percent or 5 percent (or some other figure), are you contributing this full amount?

If not, prioritize this above all else. That match is part of your compensation. Not collecting it is the equivalent of turning away part of your paycheck.

#3: Are You Saving Enough for Retirement?

As a general rule of thumb, you should contribute at least 15% of your paycheck towards retirement savings.

Are you already contributing at least this much money? If not, then focus on boosting your retirement contributions until you meet this goal. If you're on-track, however, it's time to consider other factors.

#4: Don’t Forget About Taxes

Contributions to a Traditional 401k and Traditional IRA are tax-deferred, meaning you won’t pay taxes on them until you reach retirement and actually start using them. If you’re making $80,000 and you decide to contribute the maximum amount to your 401k (let’s say you’re under 50 and it's the year 2015, so you can contribute a maximum of $18,000), that means the IRS will only be taxing you on the remaining $62,000 of your income. 

When you hit retirement age, if you’re in a lower tax bracket (which you may be due to your reduced income), that $18,000 in your 401k will be taxed at a lower percentage than it would be now. In other words: a win now and a win later.

In comparison, if you were to take that $18,000 and put it towards your vehicle loan, you're paying with after-tax money. In this case, you’ll actually be putting less than $18,000 towards your loans.

An income of $80,000 would put you in the 25% tax bracket, for instance, but that's a marginal rate (rather than an effective rate). Let's assume your effective tax rate is 20 percent, in which case, that $18,000 would only wind up coming to $14,400 after taxes were deducted.

In other words: you could invest more money than you could spend in making debt repayments, assuming that you're investing in tax-deductible accounts. This might be an argument to invest.

(Of course, if you're investing in tax-exempt accounts like a Roth 401k or Roth IRA, then the two options carry the same tax implications for this current tax year. You could contribute the same amount of earnings, regardless of whether you're investing or repaying debt.)

#5: Peace of Mind

Finally, let's not ignore one other crucial factor: peace of mind.

If repaying your debt could help you sleep more easily at night, there might be a powerful argument for crushing your loans.

On the other hand, if you feel anxious about a perceived shortcoming within your retirement accounts, then investing might help calm your nerves.

Peace of mind is valuable. Don't underestimate the importance of making this financial decision with your heart and your gut, rather than trying to decide based on cold math and reason alone.