You should avoid selling investments to pay down debt — except for this one caveat, say experts – CNBC

Here’s a realistic personal finance conundrum: You have nagging debt collecting that you just can’t seem to get rid off, but, separately, funds are sitting and (ideally) growing in your investment accounts. What if you used that investment money to finally make a significant dent in your debt once and for all?

What may seem like a quick solution, however, has important financial implications to be aware of (hello, capital gains tax). When possible, experts generally suggest avoiding using your investments to pay down debt. However, there is one caveat to that rule: when you have high-interest debt.

Select, looks into the pros and cons of selling your investments to pay off debt.

If you have high-interest debt like outstanding credit card balances, it’s smart to take every measure possible to take care of that debt, advises Tony Molina, a CPA and senior product specialist at robo-advisor investment platform Wealthfront.

“When looking at this from an interest rate perspective, if you’re paying 20% interest on credit card debt, you would need to make at least 20% on your investments to cover that interest cost,” Molina tells Select. “No one makes 20% year-over-year.”

Lynn Dunston, a CFP and partner at wealth management firm Moneta Group, agrees that you can quantify the best route to take when deciding whether to pay off debt off or stay invested, but his threshold rate is much lower. Dunston provides a “common industry rule of thumb,” explaining that once the debt’s interest rate is higher than 4%, it’s harder for your investment gains to overcome the cost of interest.

“At that point, we would typically recommend you pay debt down,” he says. “Of course, this is only a general rule and specific circumstances should always be taken into account when making important financial decisions.”

A good practice, Dunston adds, is to ask yourself what is the cost of the opportunity you’re giving up by withdrawing money from your portfolio to pay down debt? He wants you to consider what your investment money is earmarked for so you can weigh what might be jeopardized if you pay off the debt.

“Money invested will grow,” Dunston says. “If the debt in question has an interest rate below 4% and the money invested earned 8%, you could walk away with the difference by staying invested. You can let it grow in an account and turn around later and use that money to pay down the debt. In this scenario, you’ll come out ahead by keeping the money invested.”

Before selling your investments, consider these alternatives

Now, while high-interest debt is the caveat here, it’s worth noting that using your investments as payment for that debt can be a last-case scenario. Sara Kalsman, a CFP at robo-advisor Betterment, says to first consider pausing contributions to your investments and prioritize directing that cash flow instead towards paying down high-interest debt at a quicker pace.

For example, you can use that cash to accelerate your credit card debt repayment and pair it with a balance transfer credit card, where your payments can chip away at your balance faster since they won’t be accruing additional interest for as long as the 0% APR introductory period lasts. The no-annual-fee Citi Simplicity® Card offers a 0% intro APR for 21 months on balance transfers (after, 14.99% to 24.99% variable; balances must be transferred within four months from account opening).

If you stopped making contributions to your investments because you ran out of money to do so — and therefore have no other funds to redirect towards your high-interest debt or a balance transfer card — there’s also a second option to consider before selling your investments. Molina advises instead using any available line of credit from your investment portfolio, which essentially means borrowing against your brokerage account. Many major brokerages offer a portfolio line of credit, including Wealthfront, M1 Finance and Charles Schwab.

“If you sell investments to pay off debt, you’ll owe capital gains tax, which can be as high as 37% if you held those investments for less than a year,” Molina explains. “Taxes can seriously eat away at your returns.”

By taking out a loan through a portfolio line of credit, you can get access to your investment money without triggering taxes. Borrowing against your portfolio does however charge interest, but it’s a good option for short-term financing needs (three to six months), such as accelerating your repayment of any high-interest debt.

Lastly, whatever you do, avoid tapping into your retirement accounts if you’re considering using your investments to pay off debt. Withdrawals from your 401(k) are subject to ordinary income taxes, plus withdrawing early before age 59½ will most likely prompt a 10% penalty fee. “[It] could have a significant impact on your ability to achieve your long-term financial goals,” Kalsman adds.

We know that revolving credit card debt is considered high-interest debt, but what about installment debt like auto loans, student loans and mortgages?

Since these are generally lower-interest debts, you don’t necessarily need to rush them pay them off — especially at the expense of selling your investments to do so. Plus, the interest you pay on a mortgage and student loans is tax deductible.

Kalsman adds that it may not make mathematical sense to put excess cash towards these debts if you have refinanced or taken out a new loan in recent years at favorable rates.

“Generally, you should prioritize the debt from highest interest rate to lowest,” Dunston says. “If it’s below 4%, there’s an argument to keep your money invested but it can also depend on how it’s invested: high-growth portfolios or low-yielding accounts where you could lose money to what’s being accumulated in debt.”

Very rarely should you sell your investments to pay off debt. The one exception here is if you have high-interest debt (like an outstanding credit card balance), but even then there are alternatives to consider before using your investments as repayment.

At the end of the day, remember the reason of why you are in debt to begin with. While debt like student loans and mortgages are arguably smart to take on, high-interest credit card debt is something you want to avoid from the beginning.

“Using an investment account to pay down debt may rid you of high-interest payments,” Kalsman says, “but this doesn’t avoid the core problem, which may be poor money habits (in some cases), such as overspending or racking up credit card bills with impulse purchases.”

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