Every TikTok financial guru and #MoneyTwitter account will give you the same advice. Max out your 401k contributions, skip the Starbucks in the morning, do 100 pushups when you wake up, and pay off your debt to reach financial independence. This may work for some people, but it’s far from gospel. Here’s an interesting fact: keeping your debt might be a good financial decision.
That’s right. By paying off your mortgage or student loans early, you may be leaving money on the table. Not all debts are bad if you consider the opportunity costs.
Return on Debt
Dave Ramsey has made a fortune on giving people this advice. Using his snowball method, people can pay off all of their debts one by one until they are all gone.
It’s hard to argue with this advice. After all, paying off your debts early will lower your total interest payments and save you money in the long run. How can this be a bad thing?
It’s not, but it might not be the best thing. If you have the ability to pay off your debt early, should you? Let’s go through a few cases to determine the best course of action. For these examples, we will use a $10,000 loan and 5% interest over 10 years.
Warning for the finance nerds! These return calculations aren’t “by the book.” They are simply a measure to gauge performance vs the base case.
Case #1: Pay Off Debt as Scheduled
This is what most people do. You make that check out to your lender every month, and nothing else. This is continued every single month until the debt is repaid. By taking on this debt, you are already signed up to pay interest for the life of this loan. This will be our base case. Return = 0%.
Case #2: Pay Double Each Month
So, you started saving some money and want to try the old snowball method. Good. Let’s see how that works out for you.
Not too shabby. By paying twice as much as the minimum, you can improve on your base case by 1.28% over 10 years. That might not sound like a lot, but that comes out to $1,550. That’s a good chunk of change.
Case #3: Pay It All Off in Year 1
So, what if you paid it all at once? Let’s take a look.
Paying it all off at the end of year 1 saves you nearly $2,500. Over 10 years, this equates to a 2.12% return over the benchmark.
So what’s the problem? Paying off your loans early seems like a good idea–and it is. But instead of saving to pay off your debt early, you could invest that extra money.
Return on Investment
Let’s take a look at these scenarios.
Case #4: Minimum Debt Payment + Investment with 5% Return
This case requires the same contributions as Case #2. You have to pay your debt, so that’s not going away. But instead of doubling down your payment, you invest that money instead. Let’s say you find an investment that pays 5% per year–the same interest rate as your debt. That should be the same as paying off your debt, right?
Wrong. Even if you wait to invest until the end of the year, you still end up with more money than any of the first three scenarios. By contributing to an appreciating asset–like stocks–your returns increase at a faster rate than your debt.
Case #5: Minimum Debt Payment + Investment with 3% Return
When the rates are equal, you win by investing. What if the debt rate is higher than your return?
Compared to Case #2, you are still better off investing. Even if your return is slightly lower than your interest payment, you still end up with more money by investing.
This is how compounding works for you. With every contribution to your investment portfolio, assuming a constant positive return, your overall return goes up. With every contribution to your debt, your overall return also goes up. Win-win.
In each case, the balance increases when the interest/return kicks in. But when you invest, you get a return on the contributions and on the gains themselves. Double win.
Case #6: Minimum Debt Payment + Lump Sum Investment with 5% Return
If you have ten grand in your pocket and can afford your usual payments, what do you do? You can pay off all of your debt or continue to pay the minimum while investing the rest. Let’s take a look below and compare to Case #3.
Boom! How do you like them apples?
Compared to Case #3, you would end up with $2,600 more in your pocket. If you have the money to invest, invest it right now. Compounding works for you if you let it.
The one advantage paying off debt is its guarantee. Paying off debt is a guaranteed positive return. Investments can never guarantee a return like this. Investments are inherently risky, but they come with greater returns.
Everyone’s situation is different. Some people like to pay off debts to ease their mind. Some people just can’t stand the idea of owning someone else money. That’s totally okay. If you fall into one of these groups, you still have the ability to pay off your debts.
However, if you–like me–are an efficiency hound that loves to find the best way to do everything, consider holding onto your debts. You may be able to make more money that way.
Thanks for reading!