Paying Debts Early vs Making Investments

pay-debts-or-make-investmentsShould You Pay Off Your Debt or Invest Your Money?

This article analyzes the question of whether you should apply any extra cash you might have lying around to making extra payments on a debt, or whether you should instead leave the debt on its regular payment schedule and invest the cash instead. An equivalent question is whether you should cash out an existing investment to pay down debt, or just let it ride. We’ll focus on the example of a first mortgage on a house, but the analysis works (with some changes) for a car loan, credit-card debt, etc.

Before we compare debts with investments, it’s important to frame the debate. A bit of financial planning is appropriate here; there are several articles in the FAQ about that. To start with, an individual should have an emergency fund of 3-6 months of living expenses. Emergency funds need to be readily available (when was the last emergency that you could plan for), like in a bank, credit union, or maybe a money market fund. And most people would not consider these investments. So the first thing to do with cash is arguably to establish this sort of rainy-day fund. If you have to cash out a stock to get this fund, that’s ok; remember, emergencies rarely happen at market tops.


Advantages of Paying off Debt

Before we run numbers, I’d like to point out two important issues here. The most important issue to remember is risk. Making early payments to a loan exposes you to relatively few risks (once the loan is paid, it stays paid), but two notable risks are liquidity and opportunity. The liquidity risk is that you might not have cash when you need it (but see above for the mitigation strategy of a rainy-day fund). The opportunity risk is the possibility that a better opportunity might present itself and you would be unable to take advantage of it since you gave the bank your extra cash. And when you invest money, you generally expose yourself to market risk (the investment’s price might fall) as well as other risks that might cause you to lose money. Of course the other important issue (you probably guessed) is taxes. The interest paid on home mortgages is deductable, so that acts to reduce the cost of the loan below the official interest rate on the loan. Not true for credit-card debt, etc. Also, monies earned from an investment are taxed, so that acts to reduce the return on the investment.

One more caveat. If you simply cannot save; i.e., you would cash out the investments darned quick, then paying down debt may be a good choice! And owning a home gives you a place to live, especially if you plan to live in it on a modest income.

Finally, all you can do in advance is estimate, guess, and hope. No one will never know the answer to “what is best” until long after it is too late to take that best course of action. You have to take your shot today, and see where it lands tomorrow.

Now we’ll run some numbers. If you have debt as well as cash that you will invest, then maintaining the debt (instead of paying it) costs you whatever the interest rate on the loan is minus whatever you make from the investment. So to justify your choice of investing the cash, basically you’re trying to determine whether you can achieve a return on your investment that is better than the interest rate on the debt. For example, you might have a mortgage that has an after-tax rate of 6%, but you find a very safe investment with a guaranteed, after-tax return of 9% (I should be so lucky). In this case, you almost certainly should invest the money. But the analysis is never this easy — it invariably depends on knowing what the investments will yield in the future.

But don’t give up hope. Although it is impossible to predict with certainty what an investment will return, you can still estimate two things, the likely return and the level of risk. Since paying down any debt entails much lower risk than making an investment, you need to get a higher level of return to assume the market risk (just to name one) of an investment. In other words, the investment has to pay you to assume the risk to justify the investment. It would be foolish to turn down a risk-free 10% (i.e., to pay off a debt with an after-tax interest rate of 10%) to try to get an after-tax rate of 10.5% from an investment in the stock market, but it might make very good sense to turn down a risk-free 6.5%. It is a matter of personal taste how big the difference between the return on the investment and the risk-free return has to be (it’s called the risk premium), but thinking like this at least lets you frame the question.

Next we’ll characterize some investments and their associated risks. Note that characterizing risk is difficult, and we’ll only do a relatively superficial job it. The purpose of this article is to get you thinking about the options, not to take each to the last decimal point.

Above we mentioned that paying the debt is a low-risk alternative. When it comes to selecting investments that potentially will yield more than paying down the debt, you have many options. The option you choose should be the one that maximizes your return subject to a given level of risk (from one point of view). Paying off the loan generates a rock-solid guaranteed return. The best option you have at approximately this level of risk is to invest in a short-term, high-grade corporate bond fund. The key market risk in this investment is that interest rates will go up by more than 1%; another risk of a bond fund is that companies like AT&T will start to default on their loans. Not quite rock-solid guaranteed, but close. Anyway, these funds have yielded about 6% historically.

Next in the scale of risk is longer-term bonds, or lower rated bonds. Investing in a high-yield (junk) bond fund is actually quite safe, although riskier than the short-term, high grade bond fund described above. This investment should generate 7-8% pre-tax (off the top of my head), but could also lose a significant amount of money over short periods. This happened in the junk bond market during the summer of 1998, so it’s by no means a remote possibility.

The last investment I’ll mention here are US stock investments. Historically these investments have earned about 10-11%/year over long periods of time, but losing money is a serious possibility over periods of time less than three years, and a return of 8%/year for an investment held 20 years is not unlikely. Conservatively, I’d expect about an 8-9% return going forward. I’d hope for much more, but that’s all I’d count on. Stated another way, I’d choose a stock investment over a CD paying 6%, but not a CD paying 10%.

Don’t overlook the fact that the analysis basically attempted to answer the question of whether you should put allyour extra cash into the market versus your mortgage. I think the right answer is somewhere in between. Of course it’s nice to be debt free, but paying down your debts to the point that you have no available cash could really hurt you if your car suddenly dies, etc. You should have some savings to cushion you against emergencies. And of course it’s nice to have lots of long-term investments, but don’t neglect the guaranteed rate of return that is assured by paying down debt versus the completely unguaranteed rate of return to be found in the markets.

The best thing to do is ask yourself what you are the most comfortable with, and ignore trying to optimize variables that you cannot control. If debt makes you nervous, then pay off the house. If you don’t worry about debt, then keep the mortgage, and keep your money invested. If you don’t mind the ups and downs of the market, then keep invested in stocks (they will go up over the long term). If the market has you nervous, pull out some or all of it, and ladder it into corporate bonds. In short, each person needs to find the right balance for his or her situation.


Article Credits:

Last-Revised: 14 July 2000
Contributed-By: Gary Snyder, Thomas Price, Chris Lott, John A. Weeks III