Paying down loans versus investing
Paying down loans versus investing is an investment 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 or giving you more money when the loan is paid off. This is the same benefit that you get from a fixed-income investment such as a bond or certificate of deposit (CD), which also gives you fixed amounts of money at specified future times.
Therefore, it makes sense to treat paying down a loan like a bond investment, and compare this option to your other investment options.
Example: You have a credit card with a $5,000 balance and an APR of 10%. Your current net worth is $20,000. You have received $1,000 in cash (which is included in the $20,000). You are deciding what to do with the cash.
- If you do nothing with that cash, the credit card's interest will make your net worth $19,500 in one year's time ($20,000 - 10% * $5,000).
- If you use the $1,000 to pay down the credit card, your net worth will be $20,000 - $4,000 * 10% = $19,600
- If you invest the $1,000 in a bond paying 5% (after taxes), your net worth will be $19,500 + $1,000 * 5% = $19,550.
- If you invest the $1,000 in a bond paying 10% (after taxes), your net worth will be $19,500 + $1,000 * 10% = $19,600.
As can be seen, paying down the credit card affects your net worth equivalently to investing in a risk-free asset with an after-tax return equal to the credit card's interest rate. Note the use of after-tax and risk-free, as those are important considerations.
Be certain of your loan's payment terms and conditions. You may not be entitled to skip payments, or the interest due may not be what you expect. Read the contract. In addition, check your tax records to see whether you are actually deducting the loan interest; many homeowners take the standard deduction and thus get no tax deduction from the interest payment.
Since there are several ways of calculating interest on loans (including how leap year is considered), the exact details may differ by small amounts. Bank and auto finance loans are probably very similar, but may not be identical.
As an example, take a $10,000.00 credit union loan at 6.00% interest rate for 48 months issued 1/15/12 with 1st payment due 2/15/12 and the 15th of succeeding months. The monthly payment would be $234.86 per month for 47 payments and a final payment of $234.71 and an approximate total interest of $1.273.13. The exact amount of interest depends on the exact amount paid and which day the payment is credited. Such consumer loans charge interest on the number of days and the outstanding balance each day.
On this loan, suppose you paid the $234.86 on the 10th of every month (5 days early). Because this would slightly reduce the balance each month on the principal, overall interest would be less, resulting in a final (48th) payment of 224.31 - a savings of about $10.
As another example, suppose you chose to pay a little extra each month on the 15th. Say you paid $250.00 each month on the 15th. You would then pay off the loan with 44 payments of $250.00 and a 45th and final payment of $185.43. Total interest would be 1,185.43.
If you pay extra, do you still need to make the full monthly payment the next month? If you read all the fine print in the loan agreement, almost certainly the full payment is required each month. However, most credit unions - to some degree - allow paying early or extra to then allow skipping a month's payment. So, for example, if you make three payments in July, can you then skip August, September and October? Maybe or maybe not - all depends on the policies and practices of that credit union. Some credit unions will allow 1, 2 or 3 months prepayment where you can then skip.
While mortgage loans could operate the same way, almost none do. Mortgages operate with somewhat different rules, practices and customs. Mortgages are almost always sold by the issuing credit union (or bank) or, if not actually sold, structured in a way where they could be sold. In almost all cases, interest is collected based on the amortization schedule - not actual days. So, for example, my mortgage payment is due the 1st of the month. BUT - whether I pay my January 1 due payment on December 25 (early) or January 10 (late, but within the grace period) - the interest paid is the same. For mortgages, if you want to pay extra to save interest, that must be specifically identified and credited according to the rules of the lender/servicer. When you pay extra and/or early to save interest, you still owe the full payment in succeeding months. One reason for mortgage loans being treated like this is that it better allows transfers and sale of mortgages from one institution to another that have very different data processing and crediting systems in place.
Peace of Mind
For many investors, the peace of mind from not having a loan is valuable. If you are in that situation, it may be worth paying off a loan at a small additional cost so that the loan will be gone.
Once a loan is paid off, your life is simplified. The money budgeted for this loan can now be used elsewhere, such as investing.
If you use money to pay off a loan and then need money later, you cannot get it back without taking a new loan, probably at a higher interest rate (such as a home-equity loan rather than a first mortgage). 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. (However, if you add money to your Traditional IRA or 401(k) rather than paying down the mortgage, you do not normally gain any liquidity advantage, since you generally cannot withdraw from the Traditional IRA or 401(k) without a penalty until you reach the appropriate age.) [note 1]
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.
If you have a student loan and might work for an employer which will forgive the loan (such as a federal or state government), don't pay it down early unless the rate is very high, as you will forfeit that benefit.
In addition, there are estate-planning considerations when deciding whether to pay off a loan. For example, credit cards are typically subject to collection after death, and yet federal student loans are discharged after death. As such, if one is planning an estate, it might not be useful to use assets to pay off federal student loans, as they would be discharged upon death (and not considered cancellation nor issued a 1099-C), and one would be better off investing those assets.
Before deciding to pay extra to retire debt early you should make sure you understand your financial situation. Is your household budget in order? Do you have an emergency fund established, and enough extra cash flow to make a difference in your loans?
Guidelines for making the choice
Usually, you should pay down the loan if the after-tax interest rate on the loan is significantly higher than the after-tax rate you can earn on a comparable bond investment (a low-risk bond investment with duration equal to the time until you will pay off the loan), and you can pay the loan down without any liquidity problems.
Here is the most likely order of priority for investments versus paying off loans; it does depend on the rates, so these examples are based on typical rates which may not be accurate at any specific time.
- Invest in 401(k) to get maximum employer match (rate may be over 100% in the first year)
- Pay down credit cards (rate 10-30+%)
- Pay down non-deductible auto or student loans, or other medium-rate loans (rate 5-8%)
- Invest in Roth IRA, deductible IRA or decent 401(k) (rate 5% on Treasury bonds)
- Pay down deductible mortgage or student loans (rate 4% after tax)
- Invest in taxable account (rate 4% on municipal bonds)
- Do not pay down subsidized loans as long as subsidy lasts (rate 0-3%)
Why use bond returns for comparison?
While you may have a higher expected return by investing in stocks, or in a mixed stock/bond allocation, rather than in bonds, that return comes with a higher risk. Unless your investments are 100% in stocks, you can choose to take a higher risk whether or not you pay down your loan, because you can sell bonds and buy stock. Therefore, a fair comparison is between paying down the loan and a bond investment with the same risk.
One way to look at the comparison is to consider the following choices.
- Invest the money with your preferred allocation.
- Invest the money in bonds.
- Pay down the loan and move an equal amount of money from bonds to your preferred allocation.
- Pay down the loan and leave the investments unchanged.
The choice between 3 and 4, while difficult, is one you have already made; you decided how much risk you were willing to take, and chose your stock/bond allocation. And the choice between 1 and 3, or between 2 and 4, is much simpler; if you pay a higher interest rate on the loan than you would by investing in bonds, you will come out ahead by paying down the loan. If you prefer 3 to 1 (higher rate on the loan), then you prefer 4 to 1 also and should pay down the loan. If you prefer 2 to 4 (higher rate on bonds), then you should invest the money according to whichever of 1 or 2 you prefer.
What type of bonds are comparable?
Paying down a fixed-rate loan gives you a guaranteed, zero-risk return, since it reduces an existing liability. Therefore, it should be compared to a bond with no credit risk. If you would be investing the money in an IRA or 401(k), the best comparison is a Treasury bond; if you would be investing in a taxable account, the best comparison is a high-quality municipal bond, which has almost no risk and usually has better after-tax returns. Note that you are generally best off putting stocks in your taxable account and bonds in tax-deferred accounts -- see Principles of tax-efficient fund placement for more information.
If your loan is at a fixed rate, the proper comparison is to a bond with duration equal to the time it will take you to pay off the loan, because that is how long it will take you to realize the benefit. For example, if you pay an extra $1,000 on your 6% mortgage, the reduced mortgage balance will decrease by 6% a year, compounded annually (but all the gains are taxable). If there are ten years left on your mortgage, you will reduce your final payment by $1791, so your prepayment is effectively a ten-year bond. If there are more than ten years left but you sell then house in ten years, you will get an extra $1791 after the loan is paid off, so it is again a ten-year bond.
If your loan is at a variable rate, the proper comparison is to a short-term bond even if it will take you a long time to pay off the loan, because you will be effectively reinvesting your savings every year at rates tied to short-term rates. For example, if your mortgage rate is 1% above the one-year Treasury bill rate, and you pay off the mortgage in ten years, your pre-tax gain will be 10.5% more than the rate of one-year Treasury bills reinvested for ten years because of compounding, no matter what happens to Treasury rates during the next ten years.
While paying down the loan gives a zero-risk return, you will still face risk from the potential change in value of an asset (such as a house) you purchased with the proceeds of the loan -- but that risk would still exist if you had purchased the asset with cash.
What is the effective rate?
If your loan interest is tax-deductible, the after-tax rate to use for comparison is the actual rate, reduced by a percentage equal to your tax bracket. For example, if your mortgage is at 6% and you are in a 30% tax bracket, the after-tax rate is 4.2% = 6% - (30% * 6%); paying down $10,000 and reducing the interest by $600 would increase your tax bill by $180. (Even if you would lose the opportunity to itemize deductions if you paid off the whole loan, treat any partial payment as a fully taxable investment, because you have to eliminate the deductible interest first before you can pay off enough to eliminate non-deductible interest.)
As another example, the first $2,500 you pay in interest on a student loan is tax-deductible up to a certain income level. Suppose you have a $60,000 student loan at 5% interest, so that you will owe $3000 of interest next year; you deduct $2500 of interest, reducing your tax bill by $375 if you are in a 15% tax bracket (375$ = ($3000 * 15%) - ($3000 - $2500) * 15%). If you pay down $10,000, you reduce the interest to $2500, and you still get the full deduction, so your benefit is the full $500 for an effective rate of 5%. But if you pay down yet another $10,000, you reduce the interest to $2000, and you lose a $500 deduction, increasing your tax bill by $75. Thus, the second $10,000 payment earns you only $425, for an effective rate of 4.25% on this payment.[note 2]
If the decision is close
If, by the sheer numbers, the decision is close, it may be better to keep the loan .
The benefits of paying off the loan would be:
- Psychological benefits
- Reduced minimum monthly payments, which could be useful in an emergency situation.
- Tax-free return.
The benefits of keeping the loan and investing in bonds would be:
- Liquidity (you can likely choose to sell the bonds and pay the loan off at any time)
- If interest rates fall, you can likely refinance the loan at a lower rate.
- Fixed-rate loans (e.g. mortgages) can offer inflation protection (if inflation rises, you are still only paying the same nominal amount per month).
- If the choice is between investing in tax-advantage accounts (e.g. 401(k) or IRA) and paying down the loan, investing in the 401(k) or IRA will give you more tax-deferred investments, which will remain valuable even after you have paid off the loan, and these accounts have annual contribution limits.
- Early withdrawals are generally amounts distributed from your Traditional IRA account before you are age 59 1/2. You must pay a 10% additional tax on the distribution of any assets from your Traditional IRA before you are age 59 1/2.
- Exceptions to the penalty apply if the early withdrawal is:
- made to a beneficiary or estate on account of the IRA owner's death,
- made on account of disability,
- made as part of a series of substantially equal periodic payments over your life or life expectancy,
- made to pay for a qualified first–time home purchase,
- not in excess of your qualified higher education expenses,
- not in excess of certain medical insurance premiums paid while unemployed,
- not in excess of your unreimbursed medical expenses that are more than a certain percentage of your adjusted gross income, or
- due to an IRS levy.
For a Roth IRA, withdrawals of contributions can be withdrawn tax free, under the ordering rules. If the Roth IRA has passed the five year holding requirement, withdrawals of qualified earnings will be tax free for the following exceptions:
- you become disabled, distributions attributable to your disability,
- qualified first-time homebuyer distributions,
- made to a beneficiary or estate on account of the IRA owner's death.
- Exceptions to the penalty apply if the early withdrawal is:
- The effective rate is the annual rate of interest when compounding occurs more than once per year. See: Effective Annual Interest Rate - Investopedia
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