Pay Down Debt or Save?

With savings rates increasing, it's harder to figure out whether to pay down personal debt or save money in an interest bearing account that say's it pays more than your debt rate. Do you put money in an account that pay's 5.6% or pay down a car loan at 4%?

Here's how to figure out your best move:

First of all, personal debt is not tax deductible. In other words, don't use this analysis for your mortgage or business debt.

Next, to properly analyze the best option, look beyond the interest rate numbers.

Find out your average tax rate by adding your Federal and State average rates. (Average rates are the amount of tax you pay on all you income. Most preparers put this number on the cover page of your returns. If you do your own taxes, take the amount of tax you paid and divide it by your Income to figure out your average rate.)

Take your average rate and subtract it from 100.

Use your answer in this equation:

Savings rate option times (average tax rate - 100) equals real rate of return. Compare with debt rate.  If your debt rate is more than your real rate of return on savings, pay off the debt rather than save.

In the example above this person has an average combined tax rate of 40%. 5.6% X 60% = 3.36%. The best option is to pay down the car loan at 4% because after taxes, it costs more than what she would earn in savings.

Barbara Bachelder, CFP for Wealth by Design, LLC