One of the most popular debates among Personal Finance enthusiasts is that of “paying down debt” versus “investing.”
For example, people ask:
“Should I pay down my mortgage or add to my 401(k)?”
-or-
“Should I pay off my student loans or open a Roth IRA?”
Although the debt and the investment may differ from one scenario to another, the underlying dilemma remains the same.
Should someone apply the excess money in their budget to outstanding loan balances or to investments?
The answer may depend on the specific debt and investment in question OR it may just depend on who you ask.
Most responders can be grouped into one of the following 3 categories:
- The Investors – People that view debt as part of the balance sheet – using terms like “leverage.” They believe paying down low-interest debt is preposterous and great wealth can be earned in the stock market.
- The Dependable Dependers – People that you can always count on to reply, “it depends.” They’ll tell you that personal finance is “personal” and they’ll need to know more about your current situation.
- The Debt-Freeks – People that want to become debt free as quickly as possible because they view debt as form of financial slavery.
With such differing opinions, which group should you listen to?
Assets Minus Liabilities Equals Net Worth
If…
Assets minus Liabilities equals Net Worth
…then you can increase your wealth by both adding to your investments (assets) and paying down your debt (liabilities).
There have been a lot of people that have increased their wealth by reducing their liabilities. But, a lot of people have also increased their wealth by increasing their assets. With there being a respectable argument for both sides, the most popular response among Personal Finance Gurus is “it depends.”
What does it depend on?
If you can receive annual investment returns greater than your annual interest rate, then you should invest your money.
If you cannot receive annual investment returns greater than your annual interest rate, then you should pay down your debt.
Rather than accepting this common philosophy as fact and calling it a day, I am going to break down:
The Actual Math Behind Paying Down Your Mortgage vs. Investing
Let’s assume that Abe has owes $100,000 on his mortgage and the rate on his 30-year mortgage is 3%. Abe understands the importance of spending less than he earns and identifies $500 of disposable cash in his budget. If Abe can earn an average annual return of 3%, should Abe invest his extra $500/month or apply the extra $500/month to his mortgage?
According to the debt payoff calculator on Dave Ramsey’s site:
The regular monthly payment on Abe’s mortgage is $421. By applying an extra $500/month, Abe can pay off his mortgage fully in 10 years and 7 months (19 years and 5 months earlier than expected). This leads to early payoff savings of $34,976. WAHOOO!
Then, with NO MORTGAGE PAYMENT, Abe can invest $921/month (his regular + extra payment) for 19 years and 5 months because he is DEBT FREE.
According to this compound interest calculator, investing $921/month for 19 years and 5 months while earning an annual return of 3% yields Abe a future value of $287,173.
In Summary:
If Abe decides to focus on his mortgage before he invests (at an investment return equal to his interest rate), he will be DEBT FREE and have $287,173 at the end of 30 years.
If Abe only makes the minimum payment of $421 on his mortgage, then it will take him longer to become DEBT FREE. Rather than being DEBT FREE after 10 years and 7 months, it will take him the full 30 years. But, on the other hand, Abe’s investments have more time to grow.
According to the same compound interest calculator, investing $500/month for 30 years while earning an annual return of 3% yields Abe a future value of $291,370.
In Summary:
If Abe decides to focus on investing before paying down his mortgage (at an investment return equal to his interest rate), he will be DEBT FREE and have $291,370 at the end of 30 years.
Therefore, even when your average annual investment returns are equal to the interest rate on your debt, investing leaves you slightly better off. But, the difference of $4,197 is rather insignificant when recognized over 360 months. In fact, the difference is only $11.66/month. **This difference can be attributed to the fact that most loans are “simple interest” whereas investment returns are “compound interest.”
So, with an insignificant difference of $11.66/month, why are some financial gurus in favor of investing over paying down debt?
Because interest rates are still hovering around all-time lows and, historically, the stock market has yielded annual returns greater than these all-time lows.
For example, according to USA TODAY, the average 30-year mortgage rate is 4.14% while the S&P 500 index is up 6% this year. Additionally, the S&P 500 was up 23% in 2013, up 16% in 2012 and up 113% over the last 5 years. This is obviously following a steep decline during the financial crisis.
Historically, if you can stomach the ups and downs of the stock market, you’re likely to be much better off investing rather than paying down your mortgage. To see why, here’s…
Let’s assume that Abe has owes $200,000 on his mortgage and the rate on his 30-year mortgage is 4.14%. Abe understands the importance of spending less than he earns and identifies $500 of disposable cash in his budget. If Abe can earn an average annual return of 7%, should Abe invest his extra $500/month or apply the extra $500/month to his mortgage?
According to the debt payoff calculator on Dave Ramsey’s site:
The regular payment on Abe’s mortgage is $971. By applying an extra $500/month, Abe can pay off his mortgage fully in 15 years and 4 months (14 years and 8 months earlier than expected). This leads to early payoff savings of $79,165. WAHOOO!
Then, with NO MORTGAGE PAYMENT, Abe can invest $1471/month (his regular + extra payment) for 14 years and 8 months because he is DEBT FREE.
According to this compound interest calculator, investing $1471/month for 14 years and 8 months while earning an annual return of 7% yields Abe a future value of $429,588.
In Summary:
If Abe decides to focus on his mortgage before he invests (at an investment return of greater than his interest rate), he will be DEBT FREE and have $429,588 at the end of 30 years.
If Abe only makes the minimum payment of $971 on his mortgage, then it will take him longer to become DEBT FREE. Rather than being DEBT FREE after 15 years and 4 months, it will take him the full 30 years. But, on the other hand, Abe’s investments have more time to grow.
According to the handy, dandy compound interest calculator, investing $500/month for 30 years while earning an annual return of 7% yields Abe a future value of $609,993.
In Summary:
If Abe decides to focus on investing before paying down his mortgage (at an investment return greater than his interest rate), he will be DEBT FREE and have $609,993 at the end of 30 years.
In this scenario, Abe is MUCH BETTER OFF by focusing on investing instead of focusing on paying down his mortgage quicker. In fact, the difference is a whopping $180,405.
Isn’t it crazy that the same person, with the same income and the same budget can find themselves in a much different situation based on their choice to pay down debt or invest?
Have you cost yourself $180,405?
