Pay off Debt or Invest? What should I do with the extra cash on hand?
You’ve come into a little money. Perhaps you received a bonus at work or a small inheritance. This is enough money where you get to decide what to do with it but not so much that you can do everything – you need to make a choice. Should you invest the money or pay down debt?
Generally, the answer is to pay down debt but, as with all things financial, it depends on your specific circumstances. Let’s explore this a bit more and understand when it is actually better to invest.
First let’s review the concept of before tax and after tax money. When you make an investment, any returns on that investment will be taxed. Since this is a general article and we don’t know how much you make, let’s use a relatively low 30% tax rate. So, for every dollar you make, 30 cents will be payable in tax. Or, to say it a different way, if you are investing in something (GIC, stock market, real estate, whatever) that is earning a 5% return, you need to consider the tax effect. That investment is actually only earning 70% of 5% = 3.5%.
Debt is paid off with after tax money. So if you have credit card debt at an interest rate of 15%, you are using money that you’ve earned after tax to pay that interest.
So, let’s take a simple example. You have $1,000 extra dollars and you want to decide if you should invest in a Guaranteed Investment Certificate (GIC) earning 5% return or pay down credit card debt at 15%. The choice is pretty clear – paying off that credit card debt is almost always the first thing you should do.
But, now let’s make it a little more complicated. Let’s say you have that same opportunity to invest in the 5% GIC. But, you have no credit card or other debt and the only other debt you have is a home mortgage at 4%. Looking at the numbers at face value, you might decide that the obvious choice is to invest in that GIC at the higher rate. But let’s remember the concept of after tax dollars. If we take 70% of 5% (3.5%) that is the after tax rate of return you are getting. Now you compare the 4% for the mortgage (paid for by after tax dollars) with the 3.5% after tax return for the GIC. Now the decision swings the other way.
This decision is likely a little more complicated as there might be other reasons to keep the mortgage. There might be prepayment penalties or other reasons it makes sense to get the GIC. But if you are making your decision just on the basis of rates of return and interest rates, the key is to consider after tax dollars in the decision.
We also explore this topic in more detail on our website.