I wanted to share some of my thoughts on debt, investing and taxes.
debt and investing is a very personal thing to most people and there is no real right or wrong answer. Many people, me included, just hate any kind of debt, even though some may be willing to take out a $20k loan for a new car. They may want to eliminate this and any other debt as quickly as possible before investing.
I think many people who do run the numbers don’t always trust them or the market. Or that simply removing any debt at all makes them feel better.
I do have a Math minor so my point of view takes a look at the numbers and only the numbers. My choices on debt and investing often take place simultaneously.
Taxes – There are a surprising amount of people who do not entirely understand the way our tax system works in the United States so I’ll quickly run through an explanation for those who are new.
Taxes in the United States (and most countries) work on a bracket system on the federal and state level. as an example let’s say you make $60,000 per year and for the example we’ll say the current Federal tax bracket system is as follows:
0 – $10,000 10%
$10,001 – $30k 15%
$30,001 – $50,000 20%
$50,001 – $80,000 28%
You would owe $1000 for the first bracket (10000 x .10 = 1000).
$3000 owed for the second bracket ((30000 – 10000) x .15 = 3000).
$4000 owed for the third bracket ((50000 – 30000) x .20 = 4000).
and $2800 owed for the third bracket ((60000 – 50000) x .28 = 2800).
Your total tax bill would be 1000 + 3000 + 4000 + 2800 = $10,800 and you would pay a total of 18% of your income to federal taxes.
Each time your income raises into another bracket, all money above that point will give a larger chunk to Uncle Sam.
Deductions – these will lower your gross adjusted income. If you were able to deduct $10,000 your gross adjusted income would be $50,000. this would keep 28% of $10k($2800) in your wallet.
Standard vs itemizing deductions – everyone deducts from their income, but you have the choice to pick the standard set amount or if you want to itemize and add up each deduction. if you have a lot of things you can deduct that will equal more than the standard deduction you can choose to itemize deduction instead.
Student loans are in an interesting spot where you can use the standard deduction AND deduct the interest from your student loans on top of that. if you spent $2500 in student loan interest at 5% APR, you can deduct that 2500 from your gross adjusted income. Using the above income bracket example this will save you $700, essentially turning $2500 of money spent into $1800. another way to look at it is it will turn that 5% APR into 3.6% APR.
Investing – All of this and more should be taken into account when deciding your retirement plan with investing and here is How I look at the numbers.
Overall the market is known to grow at a rate of 7% (give or take) in the long run. Through recessions and booms if you just leave your money in diverse index funds It’s expected to end up with 7% increase in wealth each year.
If your debt has an APR much less than 7%, i would in general put the money into investments over paying off the debt. the closer you are to 7% APR or over, the more you’ll want to just pay off the debt (because you can think of it as a guaranteed return of 7% vs hoping for more than 7% return over the years).
Using the information above here are some examples:
Mortgages – Currently I have about a $150,000 mortgage at 3.75% APR
I saved $10,000. I can invest and expect to gain $700 a year from it or pay off the mortgage and save $375 per year. Investing instead of paying off debt should give me a positive gain in wealth in the long run (years or decades) of $325 per year. You may also be able to deduct your interest on your mortgage if you itemize and this could become a greater difference in benefit of investing.
If you have a car loan of $20,000 @ 1.9% APR, you could expect to save $380 per year if you paid off the whole debt or gain $1,400 per year investing with a difference of $1,020.
$40,000 in student loans at 5% APR costs $2000, investing should gain $2800. Remembering that you can and definitely should deduct student loan interest (as long as you are eligible and don’t make too much) I would expect the difference to be a couple hundred dollars more in favor of investing.
Another reason why I generally choose investments over paying off debt in these scenarios is because I’m just starting out with very little wealth. While I’m very confident in my job security, I also want to build up some savings I can use as an emergency fund should the need arise.
Words of warning –
Using money this way is essentially gambling on the market. Assuming our government and economy doesn’t completely disintegrate and crash, it’s a good bet that’s, for once, stacked in our favor.
This investing strategy you may see it costing you more in the short run due to market volatility, the gains here are expected over many years or decades in regular diverse index funds. You may feel more comfortable putting the money into your debt where you have a guaranteed savings (or return if you want to think of it that way).