August 12, 2013, 5:00 am

Should I Invest or Pay Off My Debts?

by: The Financial Blogger    Category: Pay off your Debts
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invest vs pay off debts

I recently said a lot about my debt repayment plan which will start this October with the arrival of new income (from my wife’s home day care). In one of these articles, Derek from Money Ahoy suggested that I not pay off my low interest debts (since most of them are under the rate of inflation). The idea is not that stupid as I’ve played around with the concept of low interest debts and investing many times since I started working back in 2003:

 

I borrowed 20K from my line of credit to invest in the stock market (which resulted in buying my first house with a 50K down payment!)

 

I borrowed 25K using a personal loan to buy a piece of land (which resulted in a healthy flip within 12 months)

 

I borrowed 25K from my parents to buy my second house (which resulted in a 75K profit within four years)

 

I remortgaged my house to invest in my online company (which resulted in a 6 figure income sideline)

So as you can see; to the question should I pay off my debts or invest, Ive often answered that you should invest your money instead of paying off your debts.

 

Pay Off Debts Vs Investing

 

Starting in October, I will be generating an extra free cash flow of roughly $1,000 per month. Therefore, I have two choices: I can pay off my debts quickly or I can invest that money in the stock market or in my online company. After all, I’ve been carrying these debts for a while and they don’t hurt my budget that much. Considering their low interest rates, I mostly pay principal owed when I make a payment.

 

The logic behind investing money is the difference between the investment return you could make versus the interest rate you are paying on your debt. For example, if you can invest at 5% and your debt interest is at 3%, you could think that you will be making an extra 2% return if you invest instead of paying off your debt.

 

THINK AGAIN - Personal finance is easy to understand but it’s still more complicated than that.

 

FIRST, there is tax: you pay your debts with after tax money while your 5% investment return is a before tax return. After tax, your 5% investment return is roughly 3%. Therefore, in my current example where you have the choice of investing at a net 3% return vs paying your debts at a 3% interest rate, you shouldn’t break a sweat about this decision and simply pick one.

 

THINK AGAIN There is another little factor you have to consider.

 

SECOND, there is the marvelous power of compounding interest. Let’s say you have $1,000 to use toward your debts vs investing it at 3% net in both cases. Let’s assume your debt balance is at $1,000. If you invest your money, you will be showing the following balance sheet at the end of the year:

 

Asset: $1,030 & Debt: $1,030. You then pay your $30 of interest (because it’s a due to the bank). The following year, you show the following:

 

Asset: $1,060.90 & Debt: $1,030. The magic of compounding interest made your $30 of investment return turns into $30.90 the following year while you still owe $30 in interest to the bank! Check out the result in 25 years:

 

Year Asset Total Investment Gain ($) Debt Total Interest Cost Net Worth

1

$1 030.00

$30.00

$1 000.00

30

$0.00

2

$1 060.90

$60.90

$1 000.00

60

$0.90

3

$1 092.73

$92.73

$1 000.00

90

$2.73

4

$1 125.51

$125.51

$1 000.00

120

$5.51

5

$1 159.27

$159.27

$1 000.00

150

$9.27

10

$1 343.92

$343.92

$1 000.00

300

$43.92

15

$1 557.97

$557.97

$1 000.00

450

$107.97

20

$1 806.11

$806.11

$1 000.00

600

$206.11

25

$2 093.78

$1 093.78

$1 000.00

750

$343.78

Out of nowhere, a 3% investment return makes more than a 3% interest debt. So what if you would have paid off your debt and invest the $30 per year of interest paid starting at the end of year 2? Here’s what happens:

Year Asset Total Investment Gain ($) Debt Total Interest Cost Net Worth

1

$0.00

$0.00

$0.00

30

-$30.00

2

$30.83

$0.83

$0.00

0

$30.83

3

$31.78

$1.78

$0.00

0

$31.78

4

$32.77

$2.77

$0.00

0

$32.77

5

$33.78

$3.78

$0.00

0

$33.78

10

$39.32

$9.32

$0.00

0

$39.32

15

$45.74

$15.74

$0.00

0

$45.74

20

$53.18

$23.18

$0.00

0

$53.18

25

$61.81

$31.81

$0.00

0

$61.81

 

As you can see, the end result after 25 years is a positive net worth of $343.78 (which is 34% of the $1,000 used in the first place) vs $61.81 if you decided to pay off your debt first.

 

Technically, if you can invest money and earn at least the same rate you are borrowing, it is mathematically better to invest than pay off your debts!

 

So Why This Time am I Paying Off My Debts Instead of Investing?

 

Yeah… I’m not really making much sense right now since I just wrote 800 words on how you should invest your money when you pay a low interest rate… this doesn’t make sense to still pay of my debts right? The logic is definitely killing me right now… hahaha! But there is more than mathematics in life!

 

FIRST, there is psychology. A few years ago, I really didn’t mind having debts over my head. I was confident to constantly increase my income and eventually pay them back with my big investment returns. It turned out that the more money I’ve made by leveraging, the more I spent and never use my profit to pay off debts. Today, I know I would feel better if I pay my debts instead of investing that money again.

 

SECOND, there is my financial freedom goal. I’m soon turning 32 (yikes time flies!) and I want to reach financial freedom early in my life. This means before 40 and hopefully at 35. I don’t expect to be debt free at 35 but I aim to be financially free. The freedom I seek is the one giving me the option to work when I want to work and to spend money when I want to spend money. It’s more about breaking my links with the corporate world and sitting on enough passive and semi-passive income so I don’t have to worry about my future. It doesn’t mean I will stop working, not at all. Still, I can’t reach financial freedom if I have tons of monthly payments attached to my budget. It’s impossible for me to slowdown and drop my income even momentarily.

 

 

I Still Believe In Investing Instead of Paying off My Debts… But Just Not Now

 

Once I will clear my consumer debts, I will most likely invest my extra cash flow instead of paying off my mortgage. On the other hand, if I wake up at 34 with only a $250K mortgage as a debt, I won’t mind carrying this weight on my back…especially since my house will probably be worth over $375K at that time!

 

What about you? Do you pay off your debts or invest your extra money? 

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Comments

For us, we decided to pay off my student loans. The interest rates were kind of high and I just hated having that debt!

Dude. The math may be right but you forgot to factor risk. If you lose your income AND the market crashes you are on the path of bankruptcy.

I held off all investing, paid off 60k in debt in 2 years, now I have more money to invest without the risk while working to pay off my mortgage in 7-10 years.

Once it’s gone 401k and Roths will be maxed out yearly with an avg return of 10-12% based on 10 year performance of the funds I’m in. Still some risk but its been greatly reduced by getting rid of the debt.

by: The Financial Blogger | August 13th, 2013 (7:15 pm)

Hey Michelle,

paying off an annoying debt is always a good move ;-). interest on student loans is tax deductible in Canada and usually pretty low so I guess situation can change depends on where you live!

by: Simon Oury | August 19th, 2013 (2:22 pm)

Correct me if i’m wrong, but your numbers are wrong on figure 1.

The increase in net worth is cause by the fact you didnt widthdraw that 30$ from your assets, but “used new money” to pay the interest. The 343$ in net worth increase are the interest on that 30$ over 25 years.

It is simply not possible to get any income from a debt and an asset with the same yield.

I hate my mortgage. I love investing. So I do both :)

Always a tough choice my friend,
Mark

[...] Financial Blogger wondered if it was better to pay off debt or invest.  I struggle with the mortgage paydown versus investing issue as well.  I’ve decided to do both [...]

by: The Financial Blogger | September 2nd, 2013 (6:27 pm)

@Simon,

in both figure, I use a $30 of new money. In figure #1, it is being used to pay off the interest, in figure #2, it is used to invest.

@Scott,

you are right, there is a risk factor with the market while there are none when you pay off your debts. good point!