Should You Pay Off Debt Early or Invest?
When the burden of debt and the monthly payments associated with a large loan become soul-crushing, here are a few things you should consider.
It’s an age old question:
Should you pay off an outstanding loan that is costing you ghastly amounts in interest or put the would-be payoff money into an investment? Like so many financial questions, the answer will depend on your circumstances.
First things first, let’s take a look at the impact interest can have.
If you carry a $300,000 mortgage and the bank is charging you 5 percent in interest, you’ll owe them $1,610 each month on a 30 year loan. A quick calculation tells you you’ll pay almost twice the loan amount over 30 years if you make regularly scheduled payments. This realization would lead many to simply pay off the loan early, should they have the means. Paying just $400 extra each month would pay off the loan in under 20 years as opposed to 30.
So is this the right thing to do?
Once again, it depends. What would that extra monthly payment have become if it had gone somewhere else? The borrower has to consider an alternative strategy and outcome: Depositing that $400 per month toward an investment that earns 5 percent per year over the same 20 year period would accumulate to over $164,000. A 30/70 mix of stocks and bonds has historically fit the bill.
This is sometimes called a “sinking fund.” That lump sum would sit in a liquid account. In 20 years the mortgage payment could be pulled from this account to pay off the remaining loan at the original 30 year pace, or at once for the 20 year clip. Either method adds $1,610 monthly to normal household cash flow. If life throws a curve along the way, the lump sum can be used without asking the bank for some of your overpayment back.
Why don’t more people do this?
Well, first of all it takes discipline to remember that this fund is not for emergencies or vacations (there should be a separate fund for these things). It is simply there to retire debt and allow one to play banker rather than pay the banker. Today’s low interest rates make this a compelling alternative to paying off debt early.
However, as we often advise clients, if the idea of carrying debt causes you to lose sleep at night, always consider the “cost” of stress and get it off the balance sheet regardless of the math.
