By: Tom Vilord
www.WallStreetValue.com

I am often asked by clients whether or not it makes sense to pay off their mortgage, car loans, lines of credit, credit cards, etc. We all want to be debt free and once that goal is achieved, I am sure it is a huge sigh of relief. I was there for a while until we moved last year, now I have a mortgage again. So the question is: Do I pay off my debts or do I invest the money? First things first, before you pay anything off or invest any money, make sure you have established an emergency fund. This should be up to 6 months of living expenses put away into a liquid safe account like an interest bearing savings, checking, or money market account. Once you do that, now we can address the question about paying off a debt or investing your principal. Common sense tells you that if your return on investment is better than the interest you are paying on that loan, then, invest the money. If you have a mortgage loan where you are paying 4% interest, you are probably better off investing the money if you can earn a higher return than 4%. If you have credit card debt where you are paying 18-20% interest or higher, then pay you should pay that off… NOW!

However, a few things come into play to really be able to determine what the best option is. The biggest factor is this: If you take your principal and use that to pay off a debt such as a mortgage, will you be disciplined enough to take what would have been the monthly payment, and reinvest that each and every month. Let’s assume you have $30,000 that you can invest or pay off a debt. We will invest that into the S&P 500 ETF, ticker SPY. Since inception, over 15 years ago, the average return has been just 6.74%. Here is what your investments will potentially grow to over that 10 year time period if you kept paying the monthly mortgage and invested the $30,000 principal into SPY:

Not bad. I didn’t include any monthly savings in this example.

Now, if you take that $30,000 and pay off that loan, and reinvest what would have been the monthly payment, here is what it would look like: (assume a monthly payment on $200k at 4%. Taxes, insurance, interest, etc. not included). $200,000 x 4% annually = $8,000/year or $666.66/month.

In ten years, you would have been much better to pay off the debt and reinvest the monthly savings. So, is paying off the debt a better choice? It depends. In this example it’s an obvious yes, as long as you take what was the monthly payment, and invest the money every month. The extra $666 in savings can’t be spent on material items; it has to be put back into the market to replenish the principal balance you used to pay off the mortgage.

This looks entirely different when you change the length of time. In the above example, we assumed there was 10 years left on the mortgage. If we changed it to 5 years, then investing your principal vs paying off the mortgage look pretty close, with a slight financial advantage towards paying off the debt.

Any time period less than 5 years in this example says that investing your money instead of paying off the debt would make sense.

Now keep in mind that this example we are paying off a debt that has a pretty reasonable interest rate at just 4%. If you have credit card debt at 10% interest or higher, it’s better to pay that off immediately.

If you want to use a calculator to run the numbers for yourself to see what your own personal situation looks like, use the calculator above at https://www.investor.gov/additional-resources/free-financial-planning-tools/compound-interest-calculator.

 

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