Paying Off Debt vs Investing

Anyone who gets a little extra money each week has the option to pay off debt (such as a mortgage) or investing the extra money. There are advantages and disadvantages to each option, so what you do depends on your preferences and situation.

Paying off debt has some great advantages. First of all, you get a guaranteed rate of return. For example, if your mortgage has a 6% interest rate, then paying extra money towards your principle will guarantee a 6% return.

The second big advantage of paying off debt is security. If you have no debt, then you don't need as much money to get by every month. If you lose your job, savings will go a lot further, and perhaps a part time job will cover expenses while you look for a better job. Just imagine if you didn't have a $1200 mortgage payment every month -- your money would go much further.

An advantage to investing is that there is potential to get a higher rate of return than your debt. The S&P 500 has had a cumalative average growth rate of around 9% during its lifetime. Since 9% is likely higher than the interest you pay on your debt, investing your extra money will grow your wealth faster. If you still want to pay off debt, you can do so after your investments have grown.

The table below shows some different scenarios of the future value of money a various interest rates.

Pay off debt, Scenario 1Pay off debt, Scenario 2Invest, Scenario 1Invest, Scenario 2Invest, Scenario 3
Amount per month$500$500$500$500$500
Interest Rate5%6%7%8%9%
Future Amount, 5 Years$34,003$34,885$35,796$36,738$37,712
Future Amount, 10 Years$77,641$81,940$86,542$91,473$96,757
Future Amount, 20 Years$205,517$231,020$260,463$294,510$333,943

The different scenarios assume different interest rates, and it's possible that investment returns are higher than 9% or lower than 7%. You may also have a different interest rate on your debt than what's shown. In fact, it may be wise to calculate your own WACC (weighted average cost of capital) by taking the weighted average of the interest of all your debt. A higher weighted average means you should consider paying off debt more than investing, since it will be less likely to get a better investment return. I only took returns out 20 years since if you are really trying to pay off debt, it will likely be payed off in 15 years or so (depending on many factors, of course). Note that your wealth can be considerably higher by investing rather than paying off debt, assuming you get the higher interest rate.

Another advantage to investing is that the money is available to use to for any expenses that may arise. For example, if you suddenly have medical expenses or want to purchase a car, then you can liquidate your investment and use the money where you need it. Any extra money you use to pay off debt not refundable. However, this can also be a disadvantage to investing. Since you can't spend money you don't have, paying off debt puts your money to a good cause so that you don't have to worry about your lack of self control. A growing investment is a growing temptation -- you may lose resolve, liquidate your investment, and splurge.

The principle downside to investing is that there is risk. From 2000 to 2010, the CAGR of the S&P 500 was around 0%. So on average, people who invested in the stock market were much worse off than people who payed down debt.

Personally I think it's best to pay down debt. However, you should have some savings in case you lose your job (probably around 6 months). I have 2 children and a wife that depend on me, so I want to place the least amount of risk on our family. Also, there is a large measure of peace-of-mind that is associated with being debt-free. Once you are debt free, your savings will rapidly accumulate (assuming you don't spend it all) and you won't be under the thumb of any creditors.

B. Taylor, 19 June 2010


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