There are numerous factors to consider when deciding whether to focus on paying off your debt as quickly as possible or investing your money instead. The invest or pay off debt question is as old as personal finance.
First of all, if you’re in this situation, this means that you have some extra money each month beyond your basic needs and you need to realize that alone is a huge accomplishment!
Also, you need to make sure before committing your money to either debt payoff or investing that you first have in place a decent emergency fund that will ensure that you won’t need to go into further debt if (or rather when) you have unexpected expenses.
While there is an emotional argument behind whether you should pay off your debt or invest the money (which generally heavily leans toward paying off your debt), I was curious about looking at it from a strictly financial perspective to see what financial difference it truly makes in the long run.
The absolute key here though in this analysis would be that as an alternative to paying down, the funds must be invested for the long-term and you cannot take any money out during this entire period of time.
Time value of money calculations come into play here, especially including the expected market rate that you hope to earn in your investments and inflation. In addition, I’ve factored in taxes in both scenarios (if you’ve been around here long enough you know that I focus a lot on taxes!).
COMPREHENSIVE STUDENT LOAN EXAMPLE
This is best illustrated with a comprehensive example that shows both scenarios and then compares them on a financial basis. Student loan interest is a common type of interest for millennials and is tax deductible up to certain limits, so it’s a great example to analyze.
For both scenarios we will make the following additional assumptions:
- Extra monthly amount available: $500 (this spreadsheet uses a consistent amount each month, but can be overridden to vary the monthly payments for extra debt payments and investments–just make sure to keep them the same amount for each during the same time period)
- Inflation: 3% (inflation has averaged 3.22% over the long-term)
The details related to this loan are as follows:
- Current balance: $40,000 (this is not the original amount of the loan, this is the balance that is currently owed)
- Remaining time on debt: 92 months (this is the remaining number of monthly payments due right now)
- Next payment date: 12/1/2016
- Interest rate: 6.0% (use the annual interest rate)
- Expected federal tax rate for interest deduction: 15% (enter your federal tax rate only for tax-deductible debt, including student loans up to $2,500 interest annually and mortgage debt with no limit other than the income phaseout of itemized deductions)
- Expected state tax rate for interest deduction: 4.25% (only enter your state tax rate for tax-deductible debt that is deductible in your state–some states follow the federal deduction, others do not allow the deduction and other states do not have an individual income tax)
Also, assume that if you were to invest your extra money you could expect the following:
- Market rate of return: 7% (annual returns not adjusted for inflation)
- Percentage of return that is taxable capital gain, interest & dividends: 10% (this is used to calculate taxes on income in a taxable investment account)
- Expected federal tax rate on investment income: 15% (you can find your federal tax rate by looking up your taxable income on your prior year return and checking which tax bracket applies on the IRS website)
- Expected state tax rate on investment income: 4.25% (you can find your state tax rate on your state website or through a google search)
Below is a summary of the results of the analysis with further details being shown below.
ANALYSIS: PUT EXTRA $500 INTO PAYING OFF DEBT
If you decide to put your entire $500 extra every single month into your debt payment, it will save you a significant amount in the total interest you have to pay. On the other hand, you will miss out on the return you could receive from investing that money instead.
In total, you will cut your loan term down from 92 months to 43 months.
Your total interest paid with the extra payments will be $4,518 instead of $10,001. However, you will miss out on additional tax deductions for that interest, since student loan interest is tax deductible up to $2,500. In the case of early debt payoff, you’ll still receive a $870 interest deduction during that time period.
Therefore, the real interest expense is $3,648. The actual inflation-adjusted interest you’d pay is $3,514.
However, an important consideration here is that after the loan is paid off you then have the extra $500 to invest instead of putting toward debt as well as the regular monthly debt payment. In this case that payment was $543.49 (this can be found on the loan amortization schedule tab titled “Loan-Extra Payments” in the spreadsheet). Starting at the 44th month, you now have a total of $1,043 to invest every month.
Although you are starting much later than the alternative scenario, you are investing a lot more money each month. This will result in an approximately $6,651 inflation-adjusted return over the remaining 49 months.
Paying down the loan and then investing the payment and extra monthly payment would result in a net gain for this 92 month period of $3,137. This net gain is the difference between the investment gain (money TO you) of $6,651 and the interest expense (money FROM you) of $3,514.
ANALYSIS: PUT EXTRA $500 TOWARD TAXABLE INVESTMENT ACCOUNT
You may instead choose to put your extra money in an investment account that you feel will make a larger return that the interest rate on your debt.
If instead you take the full $500 and invest it in a taxable account, you will pay the full $10,001 in interest toward the student loan, but would receive a larger tax deduction and would end up with an inflation-adjusted amount of $7,458 in interest paid (less tax benefit received) over the 92-month loan term.
The investment gains would more than compensate for the additional loan interest paid. As shown, the investment gain & income would be $14,719 at a 7% rate of return, even after factoring in taxes owed on those amounts. After adjusting for inflation, your total investment gain would be $12,592 in today’s dollars.
You would receive a net gain of $5,134 over this 92 month period from investing your additional money instead of putting it toward your loan. This net gain is the difference between the $12,592 in investment gains (money IN) and $7,458 interest expense paid (money OUT).
SUMMARY: INVESTING WINS OVER DEBT PAYMENT…IN THIS SCENARIO
Taking the difference of $5,134 net benefit for the investing scenario and the $3,137 net benefit for the paying off debt early scenario, we receive a difference of $1,997. In other words, you will earn $1,997 more by investing your money instead of putting it toward your debt.
In addition, the balance in your investment account would be slightly larger ($1,674 difference) if you were to invest your extra money.
WHAT ABOUT OTHER ASSUMPTIONS?
While this scenario shows average inflation, market returns and a typical student loan interest rate, changing any of these factors may result in an entirely different result. This is particularly true if you estimate lower market rates of return. Market rate of return is the single-most determining factor in this analysis.
The chart below lists all the assumptions listed above, except for a change in one specific factor at a time to show an analysis of how these factors reflect the increase in returns for investing over paying off debt. The results highlighted below in the chart are the returns we calculated in our scenario above.
The most significant takeaways here are:
- In an environment of low market returns, it is much better to use your money to pay down your debt instead. Note that this makes by far the biggest difference in this analysis. Paying down debt has a guaranteed rate of return, but investing holds a significant rate risk.
- The higher the interest rate on the debt, the more advantageous it is to pay down the debt than to invest the money.
- Inflation doesn’t play a huge factor in this calculation, however, a higher inflation rate means it is less advantageous to invest the money instead of paying down debt.
- Last, higher federal and state tax rates make a significant impact as well on the returns you would be able to receive from investing vs. paying down debt. A huge factor in play here, though, is that this is tax-deductible interest. If you were to consider an automobile loan, the trend in the tax rates would actually go the opposite way, with a higher tax rate reducing the advantage of investing over paying down debt.
- Really, the only scenarios that would make it better from a financial perspective to pay down your debt instead of investing would be the risk of low market rates or an especially high-interest debt that you’re paying off.
If you are making a choice between paying down your debt or investing your money, you will definitely want to run some calculations to estimate the actual financial benefit.
The rule of thumb is that if the interest rate on the debt is higher than your expected market rate of return you should focus on paying off that debt. However, it doesn’t factor in taxes and inflation as well as the concept of market rate risk, which could have a serious impact on your financial situation.
You already know the emotional argument behind paying down debt and now you are armed with the ability to calculate the financial implications of both decisions. Now you’re ready to decide!