Posted by Mike Smith :: August 22, 2007 @ 6:54 am

Any time you have some extra money, you may wonder if you are better off investing the money or paying off your debt. The basic answer is that you should apply the money to the higher interest rate, but, as you’ll see below, that may be more complicated than you think.

When I say to apply the money to the higher interest rate, I mean that you should pay off debt if it is charging you a higher interest rate than you can get from your investment. The opposite is also true: you should invest if your investment will earn you a higher return than the interest rate on your debt.

Keep in mind that even in cases where you decide that investing seems to be the better option, you should still make the minimum payments on your debt. Staying current is not only your obligation to your lender, but will also help you avoid fees and penalties.

There are two main reasons why the trade-offs are not as straightforward as you might think.

1) Interest Rates and Investment Returns Vary.
While there are some debts out there with fixed interest rates, like P2P loans from Lending Club, many forms of debt have variable interest rates. All investments carry some risk. It’s difficult to say for sure what your return on any investment will be. Aside from the risks of the investment, your assumptions about returns may be flawed as well. Without knowing the interest charged on your debt and the returns on your investment, it becomes difficult to compare the two. You’ll probably want to play it safe and overestimate your debt costs and underestimate your projected investment returns.

2) Taxes Can Affect Debt and Investments.
When comparing interest rates, you have to take taxes into consideration as well. Some debts, such as interest paid towards a home mortgage, may be tax-deductible. Similarly, there are some investments with gains that are tax-free. To make an accurate comparison between debt and investments, you should consider both rates on an after-tax basis. To aid you with these calculations, I wrote this java applet.

By making reasonable assumptions and taking taxes into consideration, you will be well informed to decide how best to utilize your extra money.