Dear daughter,
When we have debt, a common question that arises is this one: should I pay off the debt or invest the extra cash I have?
The answer to this question can be tricky for most people. In this letter, I’ll explain to you my approach to answering this question, so you can make up your mind.
Let me give you some reasons why some of us are asking ourselves this question in the first place:
- We have debt.
- We learned that to be wealthy we need to invest. There are many ways to invest but I’m not going to explain them here.
- We already learned that an important factor in investing is time. So, the longer the time we invest the greater the benefits because the investment has more time to compound.
- Sometimes, we don’t know how to calculate how much we have to pay in interest for a debt, and we don’t know how to calculate the profit we can get for a certain investment.
I read quite a several books on these topics, blog posts, interviews, videos, etc. from people that are both, wealthy and struggling with money. I talked to some people and asked “the question” to find out what they have to say.
The answers were diverse. Some of them don’t even understand what compound interest is, or they are not interested in getting out of debt, they don’t know how to calculate the numbers.
Others have a well-defined strategy. In this group, some prefer to invest, others prefer to pay their debt.
So, my daughter, what to do if you ask yourself the previous question?
My answer is quite simple, make the numbers, and follow the ones that work better for you.
As a rule of thumb, in every single financial decision, let the numbers decide. Don’t let feelings get into it. It doesn’t matter what you feel like (in this type of decision), it does not matter what you want now, what matters most in financial decisions are the numbers.
So, let me give you an example so you can get a better picture.
Let’s say you owe $ 200 000 in a mortgage at a 5.75% interest rate, and you still have 30 years left to finish paying it; and after your expenses and your contributions to your pension fund, you still have in your pocket $1000.
Now the question, should you invest the extra $ 1000 or use it as an extra payment to the mortgage?
To see the numbers, you just need to calculate how much you are going to save in interest by paying extra into the mortgage, and how much you will earn from $1000 if you invest it for 10 years.
First, you can revisit the letter I wrote for you explaining what is a mortgage and the impact of doing extra payments and download the excel template I created for you in this link.
Or, you just can use the form below to download the excel template.
If you fill in the info related to the mortgage in the excel sheet, you will see that you have to pay in interest, on top of the money you borrowed, $220,172.46.
Now, if you make one payment of 1000, the total interest you have to pay is $215,659.63. You just save $4,512.83 by paying $1000 extra.
If you invest 1000 for 30 years, at a rate of 10% you can get $17,449.40 out of the $1000. This is of course a simplified figure, without considering the cost of investing the money and possible tax implications each year.
Looking at these figures the decision seems clear, better to invest than doing the extra payment.
However, let me show you a bit more of my situation.
In my case, the mortgage interest rate is 9.25%, and the average return of mutual funds where I stay is between 8% and 9%.
Let’s enter those numbers in the excel template and see the result.
At a 9.25% interest rate, I have to pay a total of $392,326.31 in interest payments. Adding $1000 to the first month I will pay total interest of $378,075.40, saving $14,250.91.
If I invest 1000 at an 8.5% return, I will get in 30 years $11,558.25, without considering investment cost and possible tax implications on the gains.
As you can see, I’ll be losing money.
So, my numbers tell me that I should push the extra cash towards the mortgage instead of investing it.
Notice that paying extra in a mortgage doesn’t have any extra cost. When investing, there are several extra costs that one must consider when calculating the real return of the investment.
There is also another topic to include in this analysis, it is very important. But I left it to the end because is blurrier: RISK.
For you to compare to investments (if you consider paying your house an investment), you need to adjust for the risk.
When you have a mortgage, you have a big risk. There are different ways of calculating risk. For me, the risk-adjusted price of a mortgage includes all the money that I have paid so far. Why? Simple, that is what you can lose. If you cannot pay the mortgage, you lose the house and all the money you already paid. That will be the principal plus the interest you already paid.
In the case of the investment, if you invest $1000, that is your risk. It is all that you can lose.
Imagine that I pay my mortgage for 20 years (according to the interest rate I have now, following my example). At that point, I paid $323,394.39 in interest and $71,489.82 into the principal, for a total of $394,884.20. If at that time I cannot pay the mortgage anymore, for any reason, that is the money I’ll lose.
So again, for me, the decision is quite simple.
I hope you can see now how making the numbers can help you decide what is the right decision for you.
There is also a sentimental feeling involved. Knowing that you don’t have any debt can keep you out of stress and facilitate decisions like resigning from an ill job environment and/or changing your career.
The opposite is also true, if you have a debt, knowing that you must make sure you pay the debt every month, can cause you stress and make you a slave to your current job. You cannot decide to change your job or resign, you have a debt to pay.
You can also read some myths about debt. The more you know about it the better your decisions will be.
My final comment about this topic for you is that there is no one right answer. You should make the numbers according to your situation, and depending on what the numbers tell you, you can make your own decision. Not what the financial adviser is telling you to do, or your neighbour is telling you to do, or your brother or sister-in-law.
You make your own financial decisions, and for that, you need to learn how to make the numbers.
You can use this online compound interest calculator to play with the numbers and have a clearer view of your situation.
Love you, Dad.
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