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In "general" is it better to pay off one's debt (line of credit, etc.) or is it better to invest (retirement account / RRSP or the like)? I understand that the answer will depend on terms of debt and amount of debt, inter alia, and perhaps saving and paying off debt. But I am seeking to understand the the principle that determines the answer, not the particularities that might govern one's decision.

So, at what point does the emphasis shift from one to the other?

What variables are at play here?

With thanks in advance.

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4 Answers

up vote 14 down vote accepted

It has to do with return. I don't know if Canada has a matching feature on retirement accounts, but in the US many companies will match the first X% you put in. So for me, my first $5000 or so is matched 100%. I'll take that match over paying down any debt. Beyond that, of course it's a simple matter of rate of return. Why save in the bank at 2% when you owe at 10-18%? One can make this as simple or convoluted as they like. My mortgage is a tax deduction so my 5% mortgage costs me 3.6%. I've continued to invest rather than pay the mortgage too early, as my retirement account is with pre-tax dollars. So $72 will put $100 in that account. Even in this last decade, bad as it was, I got more than 3.6% return.

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This is a good answer. Paying down debt is a good idea, but not if the money is more useful elsewhere (e.g. an employer-matched retirement contribution). –  msemack May 5 '10 at 12:48
    
thanks for a clear answer –  Rahul Kumar May 5 '10 at 22:07
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Debt creates risk. Plain and simple. Comparing interest rates of debt vs. possible investing. To me, it is all meaningless. When you are in debt, you options are limited. If you are not in debt, you have more freedom.

To me, it is a no brainer. Become debt free ASAP.

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In general, this is the approach I favor. There are nuances, but by and large getting debt free is a priority. –  MrChrister May 5 '10 at 2:21
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I think your answer is an oversimplification. Why should I pay off my car loan with a 1.9% interest rate when I can keep that money in an investment with a 4-5% yield? Just so I can claim to be "debt free"? Debt is a TOOL. You just have to use it properly and not hurt yourself. –  msemack May 5 '10 at 12:51
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I'd add that not all debt is unhealthy. For example, I wouldn't suggest forgoing putting money in savings to pay off a house or car loan early unless you got into loans that are really more than you can comfortably handle. However, paying off credit cards before saving is probably smart. –  JohnFx May 5 '10 at 15:09
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Way too simplified. You can't answer this question without talking about the interest rate on your debt, and your expected returns on your investments, and the tax issues associated with each. –  Baltimark Oct 13 '10 at 11:39
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Mike, money not put into a matched 401(k) is lost forever. The $3000 you'd use to pay off some low interest debt can be $4000 pretax deposited to the 401(k) account, and matched to become $8000. The obsession to be 100% debt free comes at its own price. –  JoeTaxpayer May 13 '11 at 2:34
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Think of yourself as a business with two accounts, "cash" and "net worth". Your goal is to make money.

"Cash" is what you need to meet your obligations. You need to pay your rent/mortgage, utilities, buy food, pay for transportation, service debt, etc. If you make $100 a month, and your obligations are $90, you're clearing $10.

"Net worth" are assets that you own, including cash, retirement savings, investments, or even tangible goods like real property or items you collect with value.

The "pay off debt" versus "save money" debate, in my opinion, is driven by two things, in this order:

  • Affect on your cash flow. (Think liquid cash)
  • Absolute return. (Think investments that are less liquid, like a CD, or mutual fund with capital gains)

If you start saving too soon, you'll have a hard time getting by when your car suddenly needs a $500 repair or you need a new furnace. You need to improve your cash flow so that you actually have discretionary income. Pay off those credit cards, then start directing those old payments into savings and investments.

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Depends upon the debt cost. Assuming it is consumer debt or credit card debt, it is better to pay that off first, it is the best investment you can make.

Let's say it is credit card debt. If you pay 18% interst and have for example a $1,000 amount. If you pay it off you save $180 in interest ($1,000 times 18%). You would have to earn 18% on 1,000 to generate $180 if it was in aninvestment.

Here is a link discussing ways of reducing debt

Once you have debt paid off you have the cashflow to begin building wealth. The key is in the cashflow.

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