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Do I Pay off Debt or Invest?

| May 11, 2016
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Debt Reduction

In my junior year of college, I enrolled in my first investment courses.  To register, I had to take a small student loan at a 3% interest rate to afford the tuition.  I was intrigued and excited by what I was learning.  I couldn’t wait to put my education to the test with a little bit of my own savings I had accumulated throughout the year.  That’s when the question hit me…….Do I pay off my student loan debt, or invest the money I saved?

I’m sure many of you have had a similar question at one time or another.  Do I pay off my mortgage, car loan, credit cards, personal loan, or student loan?  Well, here is a basic guideline that can help you in your decision.

Change the Way You Think of Debt!                                                                                            

Do not lump all of your debt payments into your expense category.  Debt is a category all on its own and here is why:

Debt has a unique characteristic when compared with expenses because it has a lifespan. We have the ability to speed up the payoff process if we choose to pay debt off quicker, or draw it out for the maximum life of the loan.  This decision comes down to opportunity cost, or the cost of an alternative that we sacrifice in pursuit of a decision.  Here is the key: 

Think of debt as negative investments 

working against your positive ones.

 Only by thinking of debts as negative investments, can we answer our original question.  Let’s assume that my investment account may average an 8% return.  For those familiar with investing, you understand that returns can be quite variable, but over a long period of time, returns can average to a much more reasonable number for analysis purposes.

Decision                      Return

Invest Savings:            +8% Variable Return
Student Loan Debt:     -3% Guaranteed Return
Net Return                  +5 % Return

In my situation, either I get a guaranteed +3% by paying off the debt and avoiding future interest on those dollars, or a net variable +5% if I choose to invest.  In this situation I can justify investing the savings.  It is important to note that this decision is taking on the volatility and risk inherent to investing, while paying off the loan is comparable to a guaranteed +3% return.

Let’s Model Another Situation

I also have a credit card with an interest rate of 9%.

Decision                      Return

Invest Savings:            +8% Variable Return
Credit Card Debt:        -9% Guaranteed Return
Net Return                   -1 % Return

Under my current investment return assumptions, it would be much wiser to pay off the credit card debt.  I can’t justify investing my dollars with the expectation of a variable +8% return, when paying off the credit card debt would be comparable to a guaranteed +9% return.

These situations should point out two important variables that you should identify in your own life.  First, what are your anticipated and past annual returns on your investments relative to your risk tolerance?  I used 8% in my example, but your situation could be much lower.  Second, be very aware of the interest rates associated with your debts.  As you compare and contrast these numbers, you will be able to better understand the answer to our original question “Do I Pay off Debt or Invest?” 

Although this strategy might not fit every person’s unique situation, it offers an effective guideline from which to start.  There can be other much more complicated variables to this question that go beyond the basics of this blog. It would be wise when dealing with these types of decisions to discuss them with your financial advisor.

 

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