Should you pay against debt faster or invest the extra money?

Some people dislike debt so much they'll put extra money against their loans even though investing that money somewhere else would give them a better financial return. The question is, how much are you willing to give up to be debt-free sooner?

There are times to pay down loans faster than the lender requires and there are times not to. When interest rates went sky-high in the early 1980s, that was a time to pay those loans down.

With the stock market flying high the last few years, that was a good time to be in the stock market and mutual funds and out of paying loans off any faster than necessary.

Hindsight is wonderful, of course. Most of us can't predict well enough what the market will do to know ahead of time which is the best way to go. If we could, we would probably change occupations.

However, poking some computer keys or even pushing a pencil with the help of a calculator can help you make a more educated decision of whether you ought to pay down debt with extra money or invest it.

Take A 10-Year Look It would be easy to calculate savings and different investments if things like taxes didn't get in your way.

But they do. That's why you will probably come up with a more accurate answer if you look at each choice in terms of where you would be in 10 years.

Here's an example to start with. You have a $100,000 loan at 8% interest and amortized over 20 years. The regular annual payment is $10,185.22.

If you make regular payments, the loan balance immediately after you make the 10th payment will be $68,343.67.

$1,000 More/Payment If, instead, you have an extra $1,000 you can put on that loan every year, you pay $11,185.22 each time, immediately after you make the 10th payment, your loan balance will be $53,857.11.

Investing $1,000 a year extra in that loan - a total of $10,000 - makes a $14,486.56 ($68,343.67 - $53,857.11) difference in your loan balance.

But, that's not quite all. Paying faster means you paid less interest. That means you saved a little less on your income tax return. When you calculate that for a 15% tax rate, the difference drops to about $13,686.

If you invest your $1,000/year somewhere else and it earns 8% interest and you pay tax on the interest income each year, your savings will grow to almost that same $13,686.

What does that tell you?

All else being equal, if you can get the same interest rate on an investment as you are paying on your loan, it's a tossup. If you hate debt, use the $1, 000/year extra to pay against your debt. If you want to build some cash savings, invest.

Of course, "all else" is rarely equal.

There's another catch, too. Debt haters may be willing to give up some investment benefit to cut debt. Just don't get too carried away with that attitude.

Here's the advantage of investment over debt repayment at several different interest rates. These are the extra dollars you would have on our example 8% loan immediately after the 10th payment if you choose to invest rather than pay down debt with that extra $1,000/year. This assumes a 15% tax rate (Table 1 on page 43).

At those higher rates, the difference from investing $1,000/year - $10,000 total - is tremendous. At 9% investment rate versus 8% on borrowed money, a debt-adverse person might choose to give up the $532 to have less debt. But as the potential for bigger returns goes up, it's hard to justify paying off a relatively low-interest rate loan. If investment interest rate drops, you could cash in the investment and put the money against the debt and be that much farther ahead.

The 15-20% earning rates may seem high. But many stocks and mutual funds went that high and higher during the past several years, and are still going strong as this is written.

Your Income Tax Rate If you're comparing investment where the earnings are taxable as you go, the comparison we've shown so far will work. When you start considering investments where the interest is tax exempt or tax deferred, it gets harder to compare.

Start talking investments that are tax deductible and tax deferred and the comparison can be a little complicated. But your results can be very good. That's what you have with tax deductible retirement plans - IRAs, SEPs and Keoghs, for example.

It helps to understand compound interest. Say, for example, you have $1,000 and it earns 8% interest this year, or $80. If you don't have to pay tax on that interest earned, next year you have $1,080. At 8%, your interest income will be $86.40. You earn $80 interest on the original $1,000. Plus, you earn $6.40 interest on the $80 of interest you earned the year before. That's like earning 8.64% on your original $1,000 investment. At the end of the second year, you have $1,166.40.

With compound interest (earning interest on interest you earned earlier), it just gets better every year.

Compare that to taxable interest. In year one, you earn $80 interest on your $1,000. But, you have to pay tax, let's say 25%, on the $80. So you only have $60 left. Your $1,060, at 8%, earns only $84.80 interest the second year. After taxes take 25% of that, you have $63.60 left. At the end of the second year, your savings is $1,123.60.

In just two years on only $1,000, you would, in that example, lose $42.80 because of taxes.

After 10 years, your tax-free or tax-deferred $1,000 would grow to $2,159. The taxed one would grow to only $1,791. The higher the tax rate and the longer you go, the wider that gap becomes.

Analysis: If you put your money in tax-deferred or tax-exempt investments, you may be ahead compared to paying down debt even if the interest rate is less.

Tax Deductible, Tax Deferred IRAs, SEPs and Keoghs can outshine paying down debt because you are using even more money that would have otherwise been paid to Uncle Sam in taxes to build your own nest egg.

Of course, someday the tax man will come. We'll talk about that later.

Consider this: If you plan to put $1,000 into a regular savings account and are in a 28% tax bracket, you have to earn $1,389 before tax to have $1,000 left after tax. That's $1,389 X 28% = $389 tax and you have $1,000 left.

Therefore, with a deductible retirement plan, you might invest $1,389 a year instead of $1,000 after tax.

Using that as an example, here's how much difference that would add up to over the years. This assumes 8% interest compounded annually and the 28% tax rate (Table 2).

If you're one who has argued against tax deductible and deferred retirement plans because, "you have to pay the tax someday and the tax rate will probably be higher then," consider this:

You could pay $89,775 of tax on that $169,938 and still have $80,163. That would be a tax rate of 52.8%.

With good tax planning, paying tax at a rate that high shouldn't have to happen.

Analysis: Most producers can build more total wealth using extra money to invest in tax-sheltered retirement plans than using that money to pay off debt at a faster pace.

There are, of course, limits on the amount you can invest in the retirement plan. Once you've hit those limits, look at other choices beyond that. Those choices may include paying more on your loans.

Consider All Factors We've tried to present a pretty complete picture of debt repayment and other alternative uses of extra money you might have. Time value of money (dollars, time and interest) is a big factor in many management decisions. Taxes are a big player, too.

One we haven't discussed much is risk. Paying debt off fast is almost risk free (unless you pay a lot off and then default). Other investments have varying degrees of risk. Savings accounts are pretty safe, but usually don't pay the highest interest. The stock market and even mutual funds come in at the other end of the range. They are higher risk, but also hold the opportunity for higher return. They can also result in a loss.

Your risk tolerance and personality are also factors to consider in making the decision of where to put extra money.

Your investment style may be like the farmer who was surprised when told that a lot of producers do invest in retirement plans, the stock market and mutual funds, for example. He sees land, hogs and facilities as his entire investment philosophy. It works for him. But many other farmers prefer to diversify.