Let me tell you a little bit about me. For years I’ve been an investor and have been fortunate enough to do well. Of course, doing well as a part time investor doesn’t mean the same thing as performing well as a hedge fund manager, but I’m proud of myself nonetheless.
In 2009, my life changed for the better. I got married! I married the perfect woman and along with this, I gained a cat. There was something else I gained that wasn’t quite as exciting: her college loans.
It’s unfortunately the case that for many people (including ourselves), getting a higher education also means falling into debt. I’ll spare you the exact figure that we’re facing, but it’s more than what my retail investment gains can pay. And soon after we got married, both of our vehicles needed replacing. Before long, I had gone from debt free with the exception of my home, to a situation where I was juggling one home mortgage, two car loans, and a lot of student loans.
I had to figure out the answer to the obvious question here: is it better to continue investing aggressively or should we pay off a large portion of our debts? The answer would have been simple if it weren’t for the fact that I love investing!
Should You Pay Off Loans or Invest Your Money?
Let’s look at my thought process that led me to a decision. Here were some of the factors I considered when making the decision to either pay off our loans or to invest our money in our Scottrade brokerage account instead.
Leverage
What caused the financial meltdown of 2008 and 2009? Leverage. Loans that were taken out by the average person and by the largest companies alike couldn’t be paid back due to a sequence of events. When the dust cleared, who was in the best financial shape? Those who were debt free. Leverage scares me and it should scare everyone as well. What if you get sick or lose your job? What if some other unthinkable event takes place that drastically changes your life? You don’t want to end up paying for the past when your future could have some rocky roads ahead.
Interest vs. Profits
Student loan payments have an interest of between 4% and 8%. Car loans have a similar interest rate. The annual interest I am paying on these loans have to be subtracted from the profits I am making on my stocks. As much as I would like to brag about my investing expertise, I don’t profit by more than 8% most years. It appears that over the life of the loans, paying the loans sooner will make me more money than if I decide to continue investing and paying the minimum payments. And this is especially true for people with outstanding balance amounts in low APR credit cards that have promotional interest rate periods that can eventually expire. Those 0% rates don’t last forever!
Paying Down Debt: It’s a Sure Thing
Let’s face it. Investing isn’t easy and doesn’t always go the way we want. We all make bad calls from time to time and sometimes it takes a long time for an investment to make the money we hope for. Paying off credit card debt, mortgages and personal loans isn’t that way. Paying a debt guarantees that you will make money (or avoid extra payments); going this route means that there will be no commission fees, no capital gains taxes, and no watching the markets and wondering. You are sure to make money.
The Disadvantages of Paying Off Your Loans
Some will argue that paying off loans will deprive you of liquid cash. Others will argue that if you pay down a loan attached to an asset that could lose value, you may be throwing money away. While there are complicated calculations that could show that paying off a loan is a less desirable financial choice, let’s look at the bottom line: most people don’t have the financial knowledge to take advantage of complicated financial instruments that could pay better than debt relief.
My Decision
So what did I do? I liquidated most of my investment accounts to pay the loans. The loans aren’t completely paid off but we’ve put a major dent in all of them. I’ve kept enough money in my investment account to have an emergency fund, but aside from that, I took it all and used it towards our loans. While I’ll miss the thrill of moving around large amounts of money, I feel great knowing that our total interest payments over time are now much less than they used to be.
Contributing Writer: Tim Parker
Copyright © 2010 The Digerati Life. All Rights Reserved.
{ 8 comments… read them below or add one }
Great article. Been investing for over 32 years, started with a borrowed $2,500. now worth 7 figures. Just paid off my mortgage using the same rationale as you. It was at 6.6%, interest only. So, by my calculations, I got 6.6% net on my money, or the equivalent of 9.42% pre-tax. Not bad. The folks who push the tax deduction aspect ( and I have been investing in real estate, too, since 1978), never mention the basic fact that, e.g. in the 30% bracket, one is sending $1.00 to Washington to get back 30 cents. Not a great investment……..
I’m a risk adverse person and think that after building up an emergency fund, debts other than a home loan should be paid off. If a home loan is all that is left, I’d split my investable money between paying down the home loan and and whatever my favorite investment vehicles are.
Paying off debt is a sure thing and I would always say it is a good idea to pay off high interest debt first before investing but if you can afford to dollar cost average a small amount of your income into a 401k or Roth IRA, it’s always a good idea too. Best bet is to stay away from high interest debt to begin with.
I agree with everyone here. I would focus on debt elimination first and foremost. It may have been a different story during the 90’s when the stock market was going gangbusters (yes, I remember those heady days quite well, and each day the market was open was always exciting!). But these, days, with the stock market see-sawing back and forth, it’s hard to make headway. With the economy still in the doldrums, the best thing to do is to be conservative and go lighter on the debt. Put your money towards your loans and debt — especially the ones that charge the highest interest rates — before attempting to invest.
Now if the investment markets improve, you’ll have to reassess your situation then.
We did the same. We paid off debt, while keeping an emergency fund. We had the money, and instead of worrying about our certain loans each month, we have more peace of mind.
If we have the means to pay off debt, I feel it’s better to use it to increase production. If we were to worry about the debt monthly, it puts a hindrance on our creative capabilities. We used the DOLP method to decide which debt to pay off first.
Yes, this is how I feel as well. I should have the last of my credit card debt paid off before the end of the year, and we are renters so there is no mortgage/maintenance/property tax debt (plus flexibility to downgrade/upgrade/relocate at will). Once that is paid off then I will pay off the ~$6K of my student loans that are at 6.8%, and once that is done then I will switch the payment on the bulk of my student loans (~$92K at about 4.5%, this is all for my PhD) from interest-only to fixed payments. Then I can start building my emergency fund (I have about 2 months worth of expenses now but would like 6 months total) and then once I have *that*, start saving for other goals and open a Roth IRA.
In India, the major loans are against Home Loan having interest @8-10%.
People get tax rebates on the same and EMI’s are Rs.1000/- per 100 Thousands. For a period of 20 years or so. This is of course calculated on the assumptions of inflation and all. If i repay part of loan of 100,000 bugs,
1) i surely will get benefit of reduction in interest of Home Loan.
2) Loan repayment tenure will get reduced.
But i strongly feel that if i Invest these 100,000 in MF which gives you returns above 20% then
1) It increases my Investment portfolio.
2) I am available with liquid cash which can compound time over time.
3) I can use this money for further contingencies.
4) I can use it for margin money for further loans for acquiring land or so.
Please let me know your comments.
By paying the loans first you have shown a good example of true asset allocation.