Home » All Posts » Debt Payoff Versus Investing Extra Cash

Debt Payoff Versus Investing Extra Cash

[Thanks for visiting Mile High Finance Guy! The website disclosure statement can be found here. Today’s post does not constitute investment, debt, or tax advice and is only educational.]

In Debt We Trust

Many Americans carry debt, and as a culture, debt is embraced. Whether it be mortgages, credit card balances, or personal or student loans, the average cumulative private debt in the US sits at a whopping $90,460 per adult. Furthermore, due to our nation’s love for borrowing, the average public debt per adult hovers around $111,481 as of writing this post. 

Fortunately, you do not need to pay off your share of the national debt directly, and instead, that burden falls on Congress through its ability to regulate spending and taxation. However, your personal debts are another story. 

Therefore, what should you do with the remaining cash once you have covered your monthly essentials? Should you pay off your debts in full or invest the surplus? Now that is a great question!

Payoff or Invest

Perhaps the first of many questions one faces on their journey to financial freedom, the payoff or invest question carries lofty weight. 

Some gurus will tell you that you must pay off all debt before building your future, while others proclaim doing so is reckless. However, all of this static leads to confusion – is there a correct answer?

Yes, there is, and as with all things in life, it lies somewhere between the lines with no one-size-fits-all approach. Nevertheless, there are important lessons to be learned by studying the question and its many answers. 

So, join me down the indebted rabbit hole – underwritten by my passion for finance and backed by my desire to type – as we embark on a short monetary journey.

Interest-ing

If you have debt, then you know that it carries interest.

The basic premise of interest is that lenders deserve compensation for loaning their money out. Thus, interest is the revenue collected to cover a loan’s cost and generate a profit for the lender. 

To make loans easier to compare, we convert interest into a percentage expressed as the interest rate, which varies greatly depending on how risky a loan is. The basic premise is that the greater the risk, the greater the interest rate.

Now, when comparing debt payoff and investing, we must weigh the value of paying off a loan outright versus investing our hard-earned dollars in hopes of appreciation. This value difference is known as the opportunity cost.

Opportunity Cost

Opportunity cost is the benefit forgone when choosing one option over another. Simply put, both options have value, but which is greater?

If you pay off debt, you curtail future interest payments and guarantee yourself savings equal to the interest rate for the loan’s remainder. 

Example: By paying off a loan with a 5% interest rate, you gain back 5% on your future cash flows.

On the flip side, if you invest, you (generally) make money through market appreciation. However, it can take time due to the market’s volatile nature in the short term.

Example: You invest money in the stock market, and it grows by 5% each year on average.

In the two examples above, paying off debt and investing both have a value of 5%. So, the opportunity cost is equal and zeroes out. 

In the real world, though, this is rarely the case.

Weighing Benefits

Debts

As previously mentioned, interest rates vary. So, the first thing to do when weighing your debts is to categorize them based on their interest rates.  

I use three subjective categories: Low, medium, and high-interest rate debts.

Low-interest rate: Debts under 4%

Medium-interest rate: Debts between 4% and 8%

High-interest rate: Debts above 8%

During the opportunity cost analysis, you should prioritize high-interest rate debts over medium and low-interest rate ones. Additionally, with low-interest rate debts, inflation helps erode their significance over time.

Investments

Concurrently, you should weigh the expected returns from investing. Usually, the greater the risk, the greater the return.

For example, a diversified stock portfolio has returned ~10% a year, while a safer 60/40 stock and bond portfolio has returned ~8.5%. However, the yearly returns vary significantly with the former, while they are more consistent with the latter. This variability is the risk we refer to when investing.

Risk generally decreases over extended periods and through portfolio diversification. What you need to determine before the analysis is what level of risk you are willing to accept in the hopes of making money. If you are unsure what level of risk is most appropriate, this post serves as a starting point

Significantly, never invest above your risk tolerance. Otherwise, you will likely sell during a market crash, which I have seen firsthand many times there over.

Consolidating It Together

Congratulations! You know how much your debts cost and what your surplus could (possibly) be earning you. Thus, you can determine the opportunity cost! 

If you have a loan that charges 4% interest but could invest your surplus cash and make 10%, the answer becomes mathematically explicit.

Example: 10% investment return – 4% debt return = 6% net gain when investing versus paying off debts outright

Thus, the logical answer would be to invest your surplus over paying off debts immediately. Otherwise, you would have a net loss of 4%. However, if you have a 22% interest rate on your credit card debt, it would be ludicrous to invest – you would be losing 12%! So make sure you evaluate each debt appropriately and always make the required payment!

Notably, before paying off any high or medium-interest debts, consider loan refinancing and consolidation. By bundling or refinancing any high and medium-interest rate debts to lower ones, your new situation makes more sense and cents due to our historically low-interest rate environment!

The Feel Good Factor

One missing piece of information I have yet to mention is the feel-good factor of paying off debt. Too often, we discuss investing and personal finance in mathematical terms. But regardless of what textbooks say, money is emotional, not mathematical, and humans make decisions based on feeling over logic

So, if paying off debt gives you the mental freedom to live your life, the opportunity cost of not paying it off will exceed any returns. However, if you can separate your emotions and money, arbitraging returns from investing and making only required payments on low-interest rate debt is the solution. But, your mileage will vary.

(Required payments are the total balance due each month, not the monthly minimum)

Final Dues

Thus, in closing, do what works best for you. If you prefer to keep things simple and want mental freedom, pay off your debts. However, if you want to reach financial freedom sooner, refinancing and investing the excess is the secret to success. Both are right, and it just depends on which side of the coin you happen to prefer.

Would you mind letting me know your thoughts below regarding your experience with debts? Have you paid them all off, or where are you in your journey to financial freedom? I look forward to hearing from you, and as always, have a great day!


Mile High Finance Guy

finance demystified, one mountain at a time






Should Gold Be In Your Portfolio?
Why Do You Seek A Financial Guru?
Buying International Stocks Is Essential, But Not Exciting

Leave a Reply

Your email address will not be published. Required fields are marked *