The answer is . . . it depends. Of course, creditor obligations must be paid in a timely manner. But what’s the best use of an unexpected financial gift? Should you use the funds to pay down outstanding debt or save for the future? Following are some tips to help you decide.
Compare the expected return on an investment to known debt expense. A balanced retirement account comprised of about 60 percent stocks and 40 percent bonds might reasonably yield an average return of 8.5 percent net of any fees. But remember, if the retirement funds are not in a Roth IRA or 401(k), the account holder will eventually pay taxes on the account’s growth at some point.
Now compare the anticipated return on the savings opportunity to the known cost of a debt obligation. For example, imagine you have a car payment with a six percent “fixed” interest rate. Unlike the retirement account, the car payment interest is static and will not fluctuate based on market conditions – your rate will always be six percent until the loan is paid off. Also, unlike an IRA, the car loan is not tax-deductible, so you will need to increase the return by your tax bracket to compare the opportunity of investing versus paying down the debt. The closer your expected return on an investment comes to the fixed cost of your debt, the more you should pay down debt. The higher the interest rate associated with a debt, the more you should focus on paying down debt.
Avoid playing the debt game. Paying off debt feels good, but many people also enjoy the sense of “freedom” that comes with a zero-balance credit card. Consistently paying down debt and then accumulating more debt because “you can” results in a “running in place” situation. Once the debt is paid off, look for opportunities to save.
Understand the cost of servicing debt. According to MarketWatch, the average American household has $129,579 in total debt and pays more than $6,600 in interest. That amount translates to approximately nine percent of household income spent solely on servicing debt.
Synchronize strategies. The more you can simultaneously save and pay down debt heading into retirement, the more exponential the impact. A dollar not spent today will reduce the income required at retirement to replace your current standard of living. You will have more savings to generate interest income because you’ve saved dollars along the way. And the debt you pay down reduces income required in the future for servicing debt. Save and pay down debt for a win/win financial future.
Expert Source: Joe Clark, CFP, Financial Enhancement Group and host of “Consider This”