Monday, June 4, 2007

Why investing over low interest debt doesn't work

Many people will argue that it doesn't make much sense to pay down a 5% interest loan when you can possibly make 10% in other investments. Let's say I have a $20,000 car loan with 5% interest for 5 years. I will be paying $2,645 in interest for the entire term of this loan. If I wanted to pay it down early, say $50/mo for the entire term, I would shave 7 months off the loan and only pay $2293 in interest, a savings of $352. I can then invest my monthly payment for 7 months and I get $3,287 assuming a 10% return. Even with the interest I saved, I'm still only ahead $3639. If I had invested that $50 for the entire 5 years alone, I'd have $3871, or $232 more.

Right? Well, I say no. Here's why.

10% (even a conservative 8%) is not going to be a short term realized return. Those statistics that investors and financial gurus boast about the market are based on 5, 10, and 20 year average returns. The shorter time I invest, the less likely I am to reach that average return. I could make more, I could make less. Investing during the entire loan term rather than after it is paid and investing the full payment is more likely to match the long term averages. Score 1 for investing rather than paying down the debt.

But all of this looks great on paper when you take out a car loan and decide to invest a certain amount above the loan. It doesn't usually work that way. What happens is you are in the middle of your loan, decide you want to get rid of that debt, and start paying it off early. Thats when people advise to invest it instead.

The problem with this is that we are goal oriented, and paying down debt - eliminating a car loan and owning our car, is a far more exciting goal than investing money and watching it grow slightly higher and all the while making car payments. Debt is a burden. So when you are deciding to pay down a debt, or invest some extra cash, what is more likely to drive you to pay more? I would say the debt. My reasoning is that you are more likely to make sacrifices and stretch your money to pay $50 a month to eliminate a debt, while you may just throw extra cash into an investment, which could be significantly less.

What should you have done? In the case of our car loan, you should have saved up for the car. If you calculate your payment of $377 earning the same 10% over 5 years and then purchase the $20,000 car with cash, you have $10,381 left over, or $14,410 if you included your $50 extra payment. Even a conservative 6% return gives you a nice 10k. Not incurring debt, saving, and paying cash pays off.

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