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Pay Down or Invest?

I got a rare phone call from my son, who normally communicates by texting: “Hey Mom, I have some extra cash, should I pay down my student loans or invest in my Roth IRA?”  With the stock market generating double digit returns recently, the answer is not a slam dunk.  So here is a systematic approach to get the answer that is right for you.

Make sure you indeed have extra cash: Do you have enough to make the minimum payments on all your debts?  What about a rainy-day fund stashed away for emergencies?  This fund should be kept in a savings account that can be accessed easily when you need it.

Analyze you debts:  Organize your debts by interest rate, so you can evaluate how much you will need to earn on investments to exceed what you pay in interest.  Are you able to deduct the interest on your tax return?  If so, the effective interest you will pay will be lower than the stated rate.

How much do you owe versus the credit available to you?  This ratio affects your credit rating, and the rate you will pay the next time you apply for a mortgage.  If you have too much debt, you may want to consider paying it down to improve your rating.

Consider the risks of investing:  You will have to balance the certainty of the interest you will be paying against the uncertainty of the returns from investments. Over long periods of time, stocks have returned an average of about 8%, bonds about 5% per year, with big swings in any given year.  Are you likely to stay invested, and not panic when the market drops? 

Bottom Line:  Invest if you are confident that the returns from your investments will exceed the interest you will be paying on your loans. 

Quote:  “Debt is the slavery of the free”  –  Publilius Syrus

Ina Fernandez CPA has 25 years of investment experience, and is currently Managing Director at Liberty Capital Management, Inc.

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