Pay off Debt or Invest?
Many Americans are struggling with multiple payments to banks and financial institutions for a variety of loans. These loans range from mortgages, auto loans, and credits cards to high interest individualized purchases on furniture, appliances, and big screen televisions. There has been a debt-free movement in America that has provided a grand vision of financial freedom and the dedication of living your dreams without the stress of money woes. Things like vacations, having proper amounts insurance, large emergency funds, and being able monetarily do as you desire; make this movement a dream for many. Does it always make sense to pay off debt? Should I invest my surplus funds and only pay the minimum?
There is no simple answer, it depends on several factors other than the obvious culprit of which interest rate is better. There are more important factors such as your personal risk tolerance, discipline level, debt tolerance, investment knowledge, desire for stability, and personal choice. I can’t imagine anyone really wants to be paying debt for 10 years, but it happens everyday as individuals simply pay the minimum payment without making any intentional choice to determine if that would be the best method to reach one’s financial goals. I simply urging you to be intentional and have a plan that gets you to your goals faster.
So, in determining whether to pay the minimum payment and invest your surplus or snowball (funds that you could pay in addition your payment.) you should analyze the following.
- Payoff date if you pay the minimum
- Amount available for your “over payment”/”snowball”
- Payoff date if you pay using snowballing method. (Piling your surplus into your balance due.)
- Investment fund balance if you invested your snowball funds throughout the “pay the minimum.” payoff date
- Interest rate of your loan vs. 8% interest rate assumed in a no-load index fund.
The information above can be used to determine if investing is a better option. There is also a calculator that can be found here (10 Financial Calculators you Need to be Using.) We can use a hypothetical situation to clarify how to best answer the question of if you should invest or pay off debt. We can use the following terms for our example:
Loan Balance $40,000, Interest 4%, Minimum $200, Payoff date 20-year term, loan type = student loan
The standard payment (principal & interest): $242 and the expected total Interest would be $18,173. It would sit around sapping your cash-flow of $250 for 20 years. If you had a household snowball/surplus of $1000 extra funds to throw at debt you have the option of throwing it as this massive loan or investing it. If you paid $1000 extra on your loan would be gone in 3 years (saving you 15,000 in interest charges).
But what if you invested those same funds in a index fund for the same term, while paying the minimum payment? (Click here to better understand investing and index funds.)
The opportunity cost of piling that money into your student loan can be bit more complex than numbers. If you pool your funds into big debt it prevents you from having a life, amassing savings, and investing at a higher interest rate than your loan. If we compare the numbers and invest the $1000 while paying the minimum payment the results would be $41,000 in three years. Looking at that, one might argue that the math looks similar. However, at this point you only owe a balance of around $37,000 and you have the ability to pay it off. But I suggest you hold out for a few more years of this same strategy; because in 3 more years that figure would be $95,007.03 and your student loan would be about $34,000. In this scenario you were able to accumulate nearly three times the balance you owe to your student loan. Now the decision is easy, pay off the loan with $34,000 and bank $60,000. This method is much more motivating than the perception of throwing your funds into the black hole of your indebtedness. You simply are building wealth through interest earned to negate the debt and interest you are being charged.
Neither scenario is right or wrong, it is your personal preference which makes more sense for how you want to spend the next 6 years of indebtedness. Personally, I lean towards investing and paying the minimum because I can change my mind at anytime and the money is available, whereas debt payments are gone. Once you pay the debt you can’t change your mind. If you have extra income to throw at a large debt, you should fully evaluate what does success and happiness look like from both sides. This will help you make the best decision for your circumstances. Student loans are prime candidates for these types of questions because they have long terms, low interest rates, and large balances.
Be sure to access your risk tolerance, knowledge, and comfortably for investing before diving into plans to put debt payoff on the back burner while you invest. If you mismanage your funds by pulling money out, reacting to the market emotional, or being to fancy you can turn this alternative method into a nightmare. The key to making this process work it actually following the plan you have written out.
Hope this helps!
*Disclaimer: This blog is not meant to give financial planning advice, it is simply giving an opinion based on logically data that can be retrieved from sources quoted within this article. There is no affiliation between this blog and any other site. Financial advice should be sought from a certified financial planner and financial decisions should be made per the readers own research and analysis. Investing involves risk and it is advised that no one invest without understanding fully the products that they are purchasing.