The Return of Paying Off Debt
When evaluating whether to pay off debt or invest, most people compare interest rates directly to expected investment returns. On the surface, this seems reasonable—if your loan costs 6.00% and you expect to earn 7% investing, the decision appears close.
But this comparison misses a critical point. Debt interest and investment returns are not apples to apples.
When you pay down debt, you are doing so using dollars that have already been taxed. So, if you are making payments on a loan, you have to incur taxes on income or investments to do so.
Similarly, when you earn a return on investments, that return is a pre-tax return. This means if you earn 7% on your investments, taxes reduce the net return to you once you pay taxes.
Converting Oranges to Apples
When you compare the after-tax return of one investment/debt to the pre-tax return of another investment/debt, you are comparing oranges to apples. They are fruits so they are related but they are different.
So to effectively compare them, you have to make them equal. You can do this one of two ways:
1) Convert everything to pre-tax
To do this, you simply take the loan rate and divide it by 1 minus your tax rate.
So if your tax rate is 22%, then the pre-tax equivalent rate for our 6% loan is 7.69% (.06 divided by (1-.22))
Now we can compare it to the investment return of 7% and see the pre-tax yield of paying down the debt is more beneficial.
2) Convert everything to after-tax
To do this, you simply multiply your pre-tax return by one minus your tax rate.
So if your tax rate is 22% and your pre-tax return is 7%, then your after-tax return is 5.46% (.07 multiplied by (1-.22)).
Now if we compare our after-tax debt return of 6% to our after-tax investment return of 5.46%, we see the same result just a different way.
Full Considerations
Comparing the return of paying down the debt is just one way to think of this decision. Here are a few other considerations:
- Tax Rate: Your Tax Rate impacts this pre-tax and after-tax calculation. If your tax rate is 0% or 37%, you may receive different results.
- Guaranteed vs Non-Guaranteed: Investment return is volatile and not guaranteed while paying down debt is guaranteed.
- Tax Considerations: Depending on the debt, there may be other tax considerations such as mortgage interest deduction.
- Liquidity: Paying down debt may reduce liquidity. While in the end it’ll boost cash flow once it’s paid off, in the short term it may reduce how much you have access to.
- Just Being Debt Free: Think of it. Most people love the feeling. Is it worth giving up maybe an extra few basis points to fully own all that you have?
Final Thoughts
Paying down debt is more than just a spreadsheet calculation – which pains me to say because I love spreadsheets.
Yes, you should get the math of it down right and know the potential tradeoffs. But you should also consider the other aspects of your financial life.