Pay off Debt or Choose to Invest? Which is Better?
Prudent financial planning has never been more important than it is now. In our recent Integrated Advisory video series, WealthCo President Sophie Blais takes us through the key elements of financial planning. Below is a synopsis of her insights.
Not All Debt is the Same
Debt can be broadly categorized into two types:
Interest-Only Debt: Where you only pay down the interest.
Amortizing Debt: Where you pay off both the interest and a portion of the principal on an ongoing basis.
Additionally, there are debts that you can deduct from your taxes and those that you can't. For example, you cannot deduct your mortgage interest from your income taxes. However, if you borrow to invest, you can potentially deduct the interest on that debt from your income taxes.
When considering interest deductibility on debt, it's important to work with your Integrated Advisory planning team to ensure you have all the information needed to make informed decisions.
Understanding Interest on Debt
There are two types of interest you might be charged on your debt:
Fixed Rate: This rate will not change. If you're paying 3% interest, you'll pay 3% interest through to the end of the term.
Variable Rate: This rate can change and may go up or down depending on circumstances.
Understanding both types of interest and the different kinds of debt is crucial for determining how and in what order to pay off your debt. We typically suggest paying down your highest interest debt first, such as high-interest credit cards. If you have multiple sources of debt, it may be worth considering debt consolidation to streamline your payments into one manageable sum.
Good Debt vs. Bad Debt
Debt can be categorized as either good or bad. For instance, mortgage debt is often considered good debt because it's an investment in property. In contrast, debt from retail purchases or vacations is usually considered bad debt. Consolidating your debt can help pay off high-interest debts and replace them with a lower interest rate, significantly improving your financial plan.
A common misconception is to pay off your largest balance first, but that's not always the best approach. Focus on paying off your highest interest rate debt first. Also, consider prepayment penalties—lenders often impose penalties for early repayment of debt. It's critical to assess these penalties and how they might impact your financial planning. Sometimes, incurring the penalties might be worth it for the peace of mind that comes with paying off debt early.
Deciding Between Repaying Debt and Investing
When deciding whether to repay debt or invest, consider whether you can earn a greater rate of return on your investments than the interest rate on your debt. Mathematically, investing might be the better option if the returns exceed the interest payments. However, personal comfort and values around debt play a significant role. If investing causes sleepless, stress-filled nights, it may not be the right option for you at this time.
Your Guide in Debt Decision-Making
Working with your Integrated Advisory planning team and having comprehensive conversations with your planner and accountant will help you make informed decisions. Even if the math suggests that investing is the better option, if it compromises your peace of mind, it might not be the right choice. Your team will be well-versed in various planning tools, the risks of borrowing to invest, and what makes the most sense for your unique situation and individual risk tolerance.
At WealthCo, we are committed to helping you navigate your financial journey with confidence and clarity. Contact us today to discuss how we can assist you in making the best financial decisions for your future.
The Integrated Advisory Network consists of a community of progressive CPA firms, along with best-in-class professional advisors, service, and product specialists, who work together to deliver an elevated and holistic client experience. One that optimizes both their personal and professional lives with an integrated financial strategy designed to help clients reach their goals. Reach out to your Integrated Advisory accountant if you have any questions or want to have a deeper conversation about your financial plan.