FREE NEWSLETTER

Step 5: Shed Bad Debt

IF FUNDING a 401(k) with an employer match is the best deal in savings, the second-best deal is paying down high-interest debt, notably credit card debt. Got a card balance costing 20% a year? Paying off that debt is like earning a guaranteed 20%—a rate of return far higher than we’re likely to earn in the financial markets.

What if we have lower-cost debt, such as student loans, car loans and mortgage debt? Much depends on what the interest rate is, whether the interest is tax deductible—and what’s the alternative use for the money.

For instance, we’ll likely earn a higher return by investing in the stock market than paying down debt that’s costing us 4% or 5% a year—and that’s especially true if we buy our stocks or stock funds in a retirement account.

On the other hand, paying down debt is often smarter than buying bonds or other conservative investments. The reason: The interest we pay on our debts is typically higher than the interest we can earn by buying these conservative investments.

What if we’re dealing with tax-deductible mortgage debt? In theory, the after-tax interest cost may be relatively low, and we should earn more by buying bonds in a tax-deductible or Roth retirement account. Problem is, thanks to 2017’s tax law, the standard deduction is now far higher. The upshot: Even if we can deduct our mortgage interest, our total itemized deductions may be barely higher than our standard deduction—meaning we are getting only modest tax savings from all the mortgage interest we’re paying.

Next: Step 6: Protect Your Pay

Previous: Step 4: Aim to Retire

Have a question or comment? Add it here:

Free Newsletter

SHARE