One question that I am often asked is whether it makes more sense to invest or pay off loans and other debt. The general answer to this question is to pay off your debts first because you will pay more in interest on your debts than you will earn on investments. A variation on this is to pay of non-deductible interest first. However, these “general answers” do not necessarily hold true in all cases.
The actual answer depends on the rate of interest you pay on the debt after tax and the after tax rate of return on your investments. Now it is important to note that in Canada that the interest you pay on debt is only deductible if the borrowed funds were used to earn income. Therefore, investment loans will have a lower after tax interest rate as compared to interest on personal loans or credit cards.
The general rule of thumb is must then be modified: If you can earn a higher, after tax return on your investments than the after-tax interest rate on your debt, then you should invest. Otherwise pay off your debts first.
The reason is simple. Your objective should be to pay the least amount of interest between the two alternatives. The additional interest you earn on the investment can be used to reduce your debt.
Consider the following:
Note: You must convert the interest rates to an effective annual rate to ensure they are comparable.
Where i is the stated annual rate, and n is the number of compounding periods per year.
If your mortgage rate is 5.25% and you are earning 8% on your investments annually, your effective annual rates on each are:
The investment income is subject to tax at your marginal tax rate.
If your marginal tax rate is 35%, then the after tax investment income is 4.4% and you are better off paying down your mortgage rather than investing.
However, if your marginal tax rate is 25%, then the after tax investment income is 6.0% and you are investing.
Another Factor To Consider
One other factor to consider is your overall level of debt and your ability to service your debt. If you have excessive amounts of debt or if you are not able to make your monthly payments and make all of your other commitments (rent, groceries, entertainment etc.) then you should concentrate on reducing your debt anyway.