It’s the age-old question and, unfortunately, there isn’t a universal correct answer. However, we can use numbers to make our decision more objective and take our emotions out of the decision-making process.
Sometimes, the decision of whether to pay off debt more aggressively or to invest more is an emotional decision rather than a mathematical one. Some people really hate having debt and it keeps them up at night thinking about owing someone else money. If debt bothers you this badly, and you’re in a position to do so, then paying off debt more quickly than required may not be a bad option.
However, there’s a more mathematically optimal way to approach the situation. But it doesn’t really matter if you take the mathematically optimal approach if you can’t feel comfortable with it. If you’re fortunate enough to be in a position to make either choice and remain financially secure, then you have to feel comfortable and secure with your decision. Otherwise, you’ll just keep thinking about it.
Time Value of Money
The concept of the time value of money must be taken into consideration to understand the mathematically optimal decision. It’s better to have (or invest) a dollar today than it is to receive (or invest) a dollar at some point in the future due to the potential that the money has to earn a compounding rate of return.
While money that you invest is expected to compound (earn returns on previous returns or earn interest on previous interest), debt amortizes which means that the balance decreases with each payment. Under an amortization schedule, outstanding interest is paid first and outstanding principal is paid with what’s left of the payment. Interest is calculated on the most recent balance of the loan which means that the amount you’re paying in interest decreases with each payment.
Let’s take a look at an example where you have two options:
Option 1
You can pay $100 extra per month towards your mortgage. You have a brand-new 30-year mortgage with a balance of $150,000 and an interest rate of 5.0%
Option 2
You can invest $100 per month in an investment that you believe will return 6% per year.
If you pay the extra $100 per month towards your mortgage, then you’d end up saving $34,606.29 in interest over the life of the loan and pay it off in 23.58 years.
That seems like a great amount of money to save in addition to shaving over 6 years off of your mortgage.
However, if you were to invest that $100 each month and received your expected rate of return of 6% over that same 23.58 years, then you would have $62,023.60.
That’s a difference of $27,417.31 by investing the money rather than paying down the mortgage faster.
If you take into consideration the balance of the mortgage in each situation at payment 283 (23.58 years x 12 months), then you’d have generated additional net worth of $9,075.31 by investing the money compared to generating additional net worth of $0 by making extra mortgage payments rather than investing the money.
Remember, the investment is compounding while the debt is amortizing.
The Risk
Of course, there’s risk involved with investing the money as the 6% probably isn’t a guaranteed rate of return (if you find one let me know) and we know that the markets don’t go up in a linear fashion. On the other hand, paying down the mortgage can almost be seen as a guaranteed return because you know that you’re going to have to pay that 5% and there’s no way to get out of doing so besides selling your house or declaring bankruptcy.
Obviously, this decision is based on the rate of return you believe you can get on the investment compared to the rate of the debt that you’re paying down. In the scenario above, if you can believe that you can get a rate of return of 2% or better, then you’d be better off investing the money rather than paying down the debt more quickly.
Opting to invest the money rather than pay down debt requires a higher risk tolerance as well as a long-term view of the markets and your personal financial life.
Liquidity
In addition to your feelings on debt and expected rate of return, there’s another factor that needs to be considered as well.
Investing the money could potentially provide more flexibility than paying down the debt more quickly. As long as your investment doesn’t go down (there’s always the chance that it does), you can probably get to your money whenever you need it if it’s in a taxable account and assuming you have invested in a liquid asset such as a heavily traded mutual fund or ETF.
Alternatively, each time you make a payment towards debt the money is no longer available to you to use for anything else. In the case of making extra mortgage payments, your money is now tied up in a largely illiquid asset where you would have to either sell the home or take out a line of credit to have access to the equity that you’ve built up in the house.
What Should You Do?
So, should you use your extra cash to pay down debt or should you invest it?
I don’t know. Do you hate having debt? Does it keep you up at night knowing that you owe someone else money? Are you okay with having debt because you believe that you can get a better return on your money over the long run? What rate of return do you believe you can get?
There are a lot of questions that need to be answered to find the right choice for you. The mathematically optimal answer isn’t always the be all end all answer because it doesn’t take into consideration individual personalities and feelings about debt and/or taking risk. You should go over considerations like these with your financial planner and determine how they fit within your personal financial plan.
