Pay off debt or invest in the future: How to make the best choice with your excess cash

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Given the low interest rate environment the U.S. is experiencing right now, many of my clients are asking essentially the same question: What should I do with excess cash? Should I pay down my mortgage or invest in my retirement portfolio? Should I pay off my auto loan or invest in my retirement portfolio? Should I use cash to build the new house or cottage, or take out a construction loan and invest in my retirement portfolio? Should I pay down my student loan debt or invest in my retirement portfolio?

Interest rates are at historic lows and consumers are taking advantage of refinancing opportunities regularly. So, what should you do? As with everything, the answer is it depends, and your personal long-term financial goals are the most important factor to consider. While there is no one-size-fits-all answer, there are factors you can consider when deciding what to do with your excess cash.

Tax mitigation

As a first step, you should evaluate your current taxable income and identify ways to reduce it. One way to do this is to make maximum annual contributions to your company-sponsored retirement plan. If you are not currently making maximum annual contributions, you should seek guidance from your financial adviser to evaluate whether you are better off maxing out your annual employee deferral to your 401(k) and receiving a current tax deduction or paying down debt with your long-term financial goals in mind.

In 2021, as an employee, you may defer up to $19,500 from your paycheck into your 401(k), 403(b), 457, and SARSEP accounts. If you are age 50 or older, you may defer up to an additional $6,500 as a catch-up contribution. By contributing to an employer-sponsored retirement plan, you are not only reducing your current taxable income, but you also are saving for your retirement.

Interest rate evaluation

If you are already maxing out your 401(k) contributions and have the financial flexibility to allocate additional cash to either debt reduction or long-term savings, you should look at each interest rate attached to your liabilities. If you have high interest rate debt, such as credit card debt, you should always work to pay this off first.

If you have relatively low interest rate debt, then you should evaluate your stage of life. If you are close to retirement and still carry significant debt, can your retirement income stream support your debt payments? If it cannot or it would limit your cash flow more than you desire, then you should consider paying down your debts first.

If you have relatively low debt or a long time until you retire, you should compare your interest rate to your expected portfolio rate of return. If you feel confident in your portfolio, are comfortable with investing and feel you could earn a rate of return meaningfully higher than the rate attached to your debt obligation, then it may be in your best long-term interest to invest in your retirement portfolio over paying down debt.

There is always a risk/reward tradeoff involved with the markets. Some years will be good and some won’t, and there are no guarantees when it comes to rates of return. Which leads us to the last consideration.

Emotional considerations

Ultimately, every action you take to advance your overall financial picture should move you closer to a place of decreased anxiety and increased satisfaction with your financial situation. If it does not, then you should discuss this concern with your financial adviser and adjust your plan.

If your debt obligations are weighing on you and keeping you up at night, then it may be best to pay them down. If you are comfortable with your overall debt exposure and you have a fully funded emergency fund sitting in your bank account, then go ahead and explore how to deploy your excess cash into your investment portfolio. The goal of financial planning is to help clients achieve their long-term goals while developing financial peace of mind. And in the end, both are of equal importance.