Should I pay extra on my student loan or invest in a Roth IRA? Build up an emergency savings fund or pay off my credit card debt? Pay off my mortgage or put more money in my 401(k) retirement plan?
These are great and common questions.
Kathy Sweedler with University of Illinois Extension has written this great article to address that trending question — “Is it better to pay down debt or build up savings and investments?”
Kathy says that like many real-life questions, the answer is not black and white. The answer is likely to be based on both objective information as well as personal values. Here are two questions I suggest asking yourself: “How can you get the most out of your dollars and what’s important to you?”
First, how can you get the most out of your dollar? We tend to be on the lookout for the “best buy” for our dollar. We know that if we spend our dollar(s) on an item (such as a movie ticket) that that dollar will not be available to do something else (like buy dessert). The opportunity cost of the movie ticket is the loss of buying dessert. In this example, a dollar is worth a dollar because the choice is, “do I go to the movies tonight or buy dessert tonight?” Both options take place now.
However, it gets more complex when the choices have longer term impacts and the dollar we have now may change in value over time. For example, dollars used to buy mutual fund shares today may increase in value over time. For the sake of simple math, let’s assume the mutual fund earns 10% over the next year. If you use $100 today to buy mutual fund shares, at the end of the year you would have $110. This is a $10 gain for your dollars.
But if you use your $100 to buy mutual fund shares, then you cannot use these dollars to do other things, like pay down credit card debt. Let’s assume you have a $100 credit card balance with an annual percentage rate (APR) of 23%. If this credit card balance is not paid, at the end of the year you would owe $123. (Assume no minimum balance required and no fees to keep this example simple.) However, if you used your $100 to pay off the credit card balance, you will save $23 in interest. You have essentially earned a return on your money (gain) of $23.
When considering an investment with a return of 10% or paying off a debt with an APR of 23%, you get more from your dollar by paying down the debt. When trying to decide how to get the most from your dollar over time, first look at the interest rates charged compared to the possible return on investment.
For some questions, the tax code makes this comparison more complicated. For example, if you have a mortgage on your home and you itemize deductions on your income taxes, the mortgage interest deduction reduces the amount of taxes you pay. Thus, a home mortgage loan at 5% interest may actually cost you less than 5%; the amount will depend on your tax bracket.
You may also have a tax-advantage if you invest money in mutual fund through an employer-sponsored retirement plan such as a 401(k). If this applies to you, then your return on your dollars invested may be more than the increase in the value of the mutual fund. Keep in mind your tax situation when thinking about the opportunity costs of your dollar.
Next, ask yourself, “What’s important to you?” Financial decision-making is more than adding up numbers. Our personal finances also are influenced by our values and personalities. Some people feel very strongly that they do not want to carry debt; this may influence their decision. Others value having emergency savings. A saving fund can provide financial security, and help avoid taking on new debt when unexpected expenses come up. Life and, to some extent, investing is unpredictable.
People’s comfort with life’s unpredictability and their risk tolerance for the up-and-down of investment returns will also influence their financial decision-making. That’s what makes the question of “what to do with my money?” both interesting and difficult.
Kathy Sweedler’s “Plan Well, Retire Well” blog can be found at extension.illinois.edu/blogs/plan-well-retire-well/
For more information on University of Illinois Unit 19 programming and to read more helpful articles, visit our website at extension.illinois.edu/ccdms , call us at 217-345-7034 or contact Cheri Burcham at [email protected].
Burnout is a state of emotional and physical exhaustion and can often be the result of long-term stress.
Cheri Burcham is the Family Life Educator at the U of I Extension. She can reached at [email protected].
