Pay off debt early or invest?

You see it everywhere, invest, invest, INVEST. Invest early or you’ll never retire!!

How do you invest effectively when your handing your hard earned money hand over fist to creditors or lien holders? If you have student loans, credit card debt, and/or auto loans are you just running in place? Don’t get me wrong, it’s great that you’re thinking about investing but are you seeing all options with eyes wide open?

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The average annual percentage (APR) rate on a undergraduate loan is around 4.5%, up to 6 to 7% for a graduate loan!

According to the Federal Reserve the average APR rate on a credit card is 15%.

The average APR rate on a 60 month auto loan is around 5.4%.

The average return of the S&P 500 over the last 20 years was 6%.

Do you play the “making money on debt” game? “Well, after my retirement contributes, and other essential expenses I have $1000 extra per month to allocate, my $35,000 auto loan only has an APR of 5% with a $660 monthly payment and I can put the remaining $340 into the stock market every month which typically returns 6-8% per year…so I am in the green! Right? Right…?”

On paper, that may be true. It is generally recommended that if your investments are projected to generate higher returns than the interest generated from your debt it would make sense to invest in those funds in lieu of paying extra on the debt.

But!…

There are no guarantees in life especially when it comes to the stock market. If you invested that $35000 in an index fund tracking the NASDAQ at the height of the dot.com bubble in 2000 it would have taken you all the way to 2015.. 15 years to break even (back to a gain of 0%), or another way of looking at it…your money would have performed worse than a savings account or CD.

But you know what is guaranteed? That car payment that comes out every month. It is SO guaranteed that if you fail to pay the bank can take that car right out of your driveway. Not only will you be without your wheels but all the money you paid up to that point.

Now I am not saying not to invest, investing is an incredible tool for wealth generation but you need to weigh that option to where you currently are in life.

So let’s fleshing out the scenario above.
Scenario 1 – Regular Debt Repayment Schedule with Remainder Invested:

Each month after paying off your rent and all other bills you end up with $1000 to do with what you want. Your car, “old reliable”, just bit the dust and now your looking for a new ride.

You end up getting bit by the “new car bug” and end up with a shiny new car that costs around $35,000 (the average price of a new car in the United States). You didn’t put anything down because why would you do that! You were approved for a “new car loan” with an APR at 5% with a loan term of 60 months. The same month your first car payment comes due you realize you should start investing! So you also open up your first investment account and put the remainder of that $1000 to work each month, approximately $340.

Now let’s see how the numbers shake out over the next 5 years…

Car Loan Typical Payment Schedule

Investing Remaining Monthly Funds

During your standard loan payment period you end up paying around $4630 in interest and have an investment account balance of around $23,700 using an average return of 6%.

Doesn’t sound too bad, so let’s look at how the numbers turn out by focusing on debt repayment first.
Scenario 2 – Accelerated Debt Repayment Schedule with Remainder Invested:

Alright, so you just bought that shiny new car and you just realized you REALLY hate car payments and wondered why you didn’t just fix “old reliable”. So you decide to try to pay off your loan as quickly as possible by forfeiting investing and focusing all $1000 per month to the car loan.

Car Loan Accelerated Payment Schedule

Investing All Funds Starting at Month 39

It takes you 38 months to pay off the balance and end up paying $2,915 in interest.

At month 39 you open up that investment account and start investing aggressively using all $1000 per month. At month 60 you end up with an investment balance of $23,194. Wait a second… if I just invested $340 a month like Scenario 1 it would have $23,700 in my investment account, what gives!

In Scenario 1 you paid $4630 in interest, over $1700 more than in Scenario 2. Where as your investment account in Scenario 1 only generated $500 more than your investment account in Scenario 2 by the end of year 5. By aggressively paying off your debt early and then aggressively investing not only did you have a car that is free and clear owned by you 2 years earlier but you also came out ahead overall by $1200, the difference in interest paid and investment return between Scenario 1 and 2!

Granted this scenario can be played out a million different ways. You could have received 0% financing, crazy 15% financing, the stock market gaining 0% per year, or 20% per year, or even losing 20% per year. If you try this out on different types of debt such as credit cards with 20% APR or student loans at 12% (yes, they do exist), it can blow your mind.

Depending on your financial health your miles may vary. Also, no plan is perfect and past performance should not be used a predictor of the future. The stock market typical behaves in cycles, with ups and downs, booms and busts.

On paper everything can look great, awesome lets do it! But when it comes into putting it into practice that is when all hell can break loose. People are emotional and are prone to making decisions not on clear and concise thought but on joy, anger, and fear etc.

“No battle plan survives first contact with the enemy. Not when the enemy is me.”

Lois McMaster Bujold

By focusing first on aggressively paying off debt not only do you have the added benefit of actually owning your car, or no longer having to think about your student loans, or credit cards, you end up having this incredible feeling of freedom and piece of mind. No longer will you have the weight hanging over your head of monthly payments.

““Whatever interest rate you have — it might be a student loan with a 7 percent interest rate — if you pay off that loan, you’re making 7 percent. That’s your immediate return, which is a lot safer than trying to pick a stock or trying to pick real estate, or whatever it may be,”

Mark Cuban (Billionaire)

…..Or your the above average person, read the above, and decided to squash that “new car bug” and ended up creating Scenario 3 – fixed old reliable, had no debt at all, and invested that $1000 per month for 60 month instead and now sitting on a nice little nest egg. Cheers!

So what are your thoughts? We would love to hear from you! Leave a comment below or send us an email via our Contact Page.

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Categories: Debt Solutions, Financial Essentials

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