By Kathy Sweedler, University of Illinois Extension Educator and blogger for Plan Well, Retire Well: Saving and investing your money
As the economy recovers, the trending question has been, “Is it better to pay down debt or build up savings and investment?” Depending on your situation the question may sound a little different such as:
Pay extra on my student loan or invest in a Roth IRA?
Build up an emergency savings fund or pay off my credit card debt?
Pay off my mortgage or put more money in my 401(k) retirement plan?
but the intent is the same. Whichever question pertains to you, I suggest you ask, “How can I get the most out of my dollars and what’s important to me?”
We tend to be on the lookout for the “best buy” for our dollar. We know that if we spend our dollars on an item such as a movie ticket that the dollar will not be available to do something else (like buy dessert). The opportunity cost of the movie ticket is the loss of buying dessert. In this example, a dollar is worth a dollar because the choice is, “do I go to the movies tonight or buy dessert tonight?” Both options take place now.
For long-term decisions we need to consider how the dollar we have now may change in value over time. For example, dollars used to buy mutual fund shares today may increase in value over time. If you use $100 today to buy mutual fund shares and the mutual fund earns a 10% annual return, at the end of the year you would have $110. This is a $10 gain.
But if you use your $100 to buy mutual fund shares, then you cannot use these dollars to pay down credit card debt. If you have a $100 credit card balance with an annual percentage rate (APR) of 23%, and the balance is not paid, at the end of the year you would owe $123. (I’m assuming no minimum payment required or fees to keep this example simple.) However, if you used your $100 to pay off the credit card balance, you would save $23 in interest cost. You have essentially earned a return on your money (gain) of $23 dollars.
When considering an investment with a return of 10% or paying off a debt with an APR of 23%, you get more from your dollar by paying down the debt. Look at the interest rates charged compared to the possible return on investing when deciding how to get the most from your dollar.
For some questions, the tax code makes this comparison more complicated. For example, you may be able to reduce your income tax liability if you itemize deductions and include mortgage interest costs. You may also have a tax-advantage if you invest money through an employer-sponsored retirement plan such as a 401(k). Keep in mind your tax situation when thinking about the opportunity costs of your dollar.
You also need to ask, “What’s important to me?” Financial decision-making is more than adding up numbers. Our personal finances are influenced by our values. Some people feel strongly that they do not want to carry debt. Others value having emergency savings. A saving fund can provide financial security, and help avoid taking on new debt when unexpected expenses come up. That’s what makes the question of “what to do with my money?” both interesting and difficult.
Both the opportunity cost of your dollar and your values are important when deciding whether to pay down debt or invest for the future. Visit the Plan Well, Retire Well blog to join in more University of Illinois Extension’s discussions about how to manage money.