Should one invest or reduce debt?

Investors face the dilemma of whether to pay down debt with excess cash or to invest that money in an attempt to turn it into even greater amounts of wealth. If you pay off too much debt and reduce your leverage, you may not garner enough assets to retire. Conversely, if you're too aggressive, you may end up losing everything. In order to decide whether to pay down debt or invest, you must consider your best investment options, risk tolerance and cash flow situation.

Pay Down Debt or Invest?

All debt is not equal. The type of debt you have can play a role in the decision as to whether to pay it off as soon as possible or put your money toward investments.

From a numbers perspective, your decision should be based on your after-tax cost of borrowing versus your after-tax return on investing. Suppose, for instance, that you are a wage earner in the 35% tax bracket and have a conventional 30-year mortgage with a 6% interest rate. Because you can deduct mortgage interest (within limits) from your federal taxes, your true after-tax cost of debt may be closer to 4%.

Student loans are a tax-deductible debt that can actually save you money. The IRS allows you to deduct the lesser of $2,500 or the amount you paid in interest on qualified student loans that were used for higher education expenses, although it phases out at higher income levels.