Paying down loans versus investing

From finiki
Jump to: navigation, search

Paying down loans versus investing is a choice you may have if you have money available but you also have an outstanding loan. This article looks at the choice of how to deploy the money and the pros and cons to be considered.

Viewing it as an investment choice

If you have money that you could invest, but you also have a loan, you have the option of using the money to pay down the loan instead. Paying down the loan will give you a guaranteed return by reducing your future loan balance, and eventually eliminating future loan payments. This is the same benefit that you get from a fixed-income investment which also gives you fixed amounts of money at specified future times. Therefore, it makes sense to treat paying down a loan like a government (risk-free) bond investment, with a guaranteed after-tax return.

Calculators

The following calculators can help evaluating scenarios:

Credit cards and consumer loans

Because it is typically not possible to find risk-free investments that pay anywhere near the interest rates on credit cards, or consumer loans, paying down such debt is typically the obvious choice.

Mortgages and student loans

Paying down mortgages or student loans vs. investing is a more difficult question.

If you are comparing pre-paying your low-interest mortgage with a balanced portfolio of stocks and bonds placed in a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) -- instead of thinking about a risk-free government bond as above -- the investment portfolio will come out ahead[1]. However this compares a risky portfolio of stocks and bonds to something that has a guaranteed return (paying down the loan), so it's not a fair comparison. Yet this is how many people think about it.

What about student loans? The logic is the same: what is the interest rate on the debt, what is the expected return on the investments, what is the time horizon, what is the tolerance for risk?[2] Interest paid on student loans is eligible for a 15% non-refundable federal tax credit (see Line 319) and provincial tax credits.

Leverage

Leverage is borrowing someone else's money to increase your returns. For example, a home mortgage uses leverage because borrowed money is used to acquire an asset. It's called "leverage" because the effect is to increase both profits and losses, much like a lever in the real world. Financial leverage allows a smaller amount of money to participate in and own profits usually possible only with a larger amount of money.

If you are deciding to invest available cash instead of paying down loans, leverage is not used directly, but the net effect is the same as borrowing to invest.[note 1]

A mortgage is sometimes viewed as a "good" use of leverage by people who think that house prices can only increase. Yet some studies have shown that mortgaged individual houses can exhibit more price volatility than a broad-market stock index (see Owning vs renting: Leverage). So conservative homeowners typically focus on paying down their mortgages quickly (at least until they have built-up substantial home equity, e.g. 50% of the current market value or more) before they invest in stocks.

Non-mathematical considerations

Peace of mind

For many investors, the peace of mind from not having a loan is valuable.

Simplicity

Once a loan is paid off, your life is simplified. The money budgeted for this loan can now be used elsewhere, such as investing.

Liquidity

If you use money to pay off a loan and then need money later, you cannot get it back without taking a new loan. Therefore, it is best to build a significant emergency fund before paying down a mortgage, and not to use money for paying down the mortgage that you might need to spend on something else other than buying a new house.

Discipline

It requires financial discipline to direct money to savings, investment, or early loan payments instead of fun things.

Once you pay off the loan, if you redirect the freed-up loan payment cash flow to increased consumption, you will have no additional savings in the end.

Notes

  1. Most often [leverage] involves buying more of an asset by using borrowed funds, with the belief that the income from the asset or asset price appreciation will be more than the cost of borrowing. Almost always this involves the risk that borrowing costs will be larger than the income from the asset or the value of the asset will fall, leading to incurred losses. See: Leverage (finance), on Wikipedia.

See also

References

  1. R. Carrick, How saving for retirement beats paying down your mortgage, February 18, 2015, viewed March 7, 2015
  2. J. Heath, Ask us: Pay off student debt or invest?, National Post, September 24, 2013, viewed March 8, 2015

Further reading

Financial Wisdom Forum

External links