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Should I Invest or Pay Back Debt?

You may be surprised with my answer!

 

Cut your spending by $6,000 without giving up the fun and without a complicated budget.

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by Rob Bertman, CFA, CFP® in Debt, Investing
June 28, 2016

Summary

I get this question VERY OFTEN. I’m sure it has crossed your mind too:

“I have some extra money. Should I invest it or pay back debt?”

This answer may surprise you.

Investing and paying back debt are the same thing.

Register HERE for the FREE webinar replay where I take a deeper dive on this topic including Q&A.

Let’s say that someone has $10,000 of student debt with a 7% interest rate. That means that they pay $700 a year in interest.

This person makes an extra $10,000 from a bonus, commissions, or their business, and they are deciding between these 2 options:

  1. Invest the $10,000 trying to earn a 7% return AND keep the student loan.
  2. Pay back the $10,000 student loan with a 7% interest rate.

(Notice that the expected investment return is the SAME as the interest rate on their debt.)

Option 1: Invest the $10,000 and keep the student loan.

They now have a $10,000 investment that EARNS $700 a year, but they still have the $10,000 student loan at 7%.  That means they are PAYING $700 of interest per year on this loan.

This person earns $700 from the investment AND pays $700 in interest on the student loan.

Let’s combine the investment earnings and interest expense paid.  It equals a NET $0 to this person.

Option 2: Pay back the $10,000 student loan with a 7% interest rate.

The debt goes away and so does the $700 annual interest payment on the student loan.  This person no longer has to pay out the $700.  This ALSO equals a NET $0 to this person.

Option 1 & Option 2 create the SAME RESULT!

Earning 7% on the investment is just like paying back debt with the 7% interest rate!

In other words, the interest rate on debt that gets paid back is equal to earning that rate on an investment.

Why is paying back debt better?

When you pay back debt, you get an IMMEDIATE RISK-FREE TAX-FREE rate of return.  Let’s break that down:

IMMEDIATE RETURN:

When this person pays off that $10,000 student debt at 7%, they no longer have to spend $700 on interest, so they IMMEDIATELY get that 7% return BACK.

RISK-FREE RETURN:

When investing and aiming for a 7, 8, or 9%+ investment return, there is risk involved. In order to get those returns they may have to weather some volatility, the ups and downs of an investment, and uncertainty that they can actually get those returns.

Some years the investment may earn 15%. Some years, it may lose 15%. Some years it may earn 0% or anywhere in between and even beyond those ranges. They have to withstand that rocky ride and battle uncertainty to potentially earn 7% return over time.

But by paying back that 7% debt, they would get that 7% return RISK-FREE without having to experience any volatility or uncertainty.

TAX-FREE RETURN:

If someone has a $10,000 investment that earns $700 in a taxable account, they may have to pay taxes on gain. Let’s say that they will owe $200 in taxes on the $700 gain. They end up netting only $500 after taxes (5% after-tax return).  Paying back that debt would earn them a 7% return WITHOUT having to pay taxes.

Paying back debt feels good 🙂

Think about if you had a $10,000 student loan. How great would it feel to have an extra $10,000 and you used it to wipe away that debt? How great would that feel?

So by paying back debt, we get an IMMEDIATE, RISK-FREE, TAX-FREE rate of return PLUS it feels good to pay back that debt, right?

After I thought about it this way, all things being equal, I prefer to pay back debt.

Want to hear more? Register HERE for a FREE webinar replay where I take a deeper dive on this topic including Q&A.

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Transcript

Hi there, I’m Rob Bertman Founder of Money With Impact and this is 5 Minute Financial Fitness.  Where we get your money in shape in 5 minutes or less by giving you great tactics, tools and strategies to help you improve your financial situation. And we do that in a way that you can easily understand and we do it in 5 minutes or less.

Now this week I want to answer a question that I get very often, “Rob, I have some extra money. Should I invest it or pay back debt?”

The answer may surprise you, but it’s essentially the same thing. Let me give you and example to show you what I mean.

Let’s say that someone has $10,000 of student debt, and they have a 7% interest rate on that debt. That means that every year, that debt costs them $700. They’re paying out $700 of interest on this $10,000 of student debt.

Now let’s say this person gets an extra $10,000, maybe they got a great bonus or maybe they crushed it in sales and get a monster commissions check, or maybe they got an extra $10,000 from their business that they didn’t realize was there that they were going to make.

Let’s say that they have 2 options.

  1. They can take that $10,000 and pay back that student debt.
  2. Or maybe they found an investment opportunity where they could invest that $10,000 and EARN 7% a year.

So they can either EARN 7% or pay back deb with a 7% interest rate.

Let’s say they decide to invest the money and keep their student debt. Option 2. Ok, so now they have this investment and every year this investment earns $700 on that $10,000 investment. They still have the $10,000 student loan at 7% also, and they’re paying out $700 of interest every year on this debt.

Let’s smush that together. So $700 comes in and $700 goes out. It’s a net $0 to that person.

Now let’s say that they decide to do option 2 and take the $10,000 to pay back the $10,000 7% interest rate student debt. Now they’re no longer having to pay $700 out, so that $700 they were paying out in interest goes to $0. So again, it’s a net $0 just like the first option.

So whether they kept the debt and invested to get a 7% return, or they decided to pay back the student debt at 7%, they end up in the same spot.

So another way to look at it is if someone pays back debt, that interest rate on that debt is essentially the same as an investment return at that rate because it nets the same thing.  So whether they bought an investment at 7% and kept the 7% debt or they paid off 7% debt, they end up in the same situation. So earning 7% is just like getting rid of paying someone 7%.

But let me tell you why all things being equal, paying off the debt is better:

When you pay back debt, you get an IMMEDIATE RISK-FREE TAX-FREE rate of return.  Let me tell you what I mean about that.

Let’s talk about IMMEDIATE:  When this person takes that $10,000 and pays off that $10,000 student debt at 7%, they no longer have to send that $700 of interest out, so they IMMEDIATELY get that 7% return back.

Now let’s talk about RISK-FREE, the 2nd part: If someone were to invest at 7%, typically when we get into the high single-digit investment returns and into 10%+ investment returns that carries some risk to get those returns over time. In order to get those returns we have to weather some volatility, the ups and downs of an investment.  Some years it may be up 15%, some years. It might be down 15%, some years it may return 0% or anywhere in between and even beyond those ranges. So we have to weather that rocky ride and end up at maybe 7% return over time. But when we pay back that debt, we get that 7% return back RISK-FREE. Because, again, paying back that interest rate is essentially like earning that same rate in an investment. It’s the same thing, and we get it RISK-FREE.

Now let’s talk about TAX-FREE: Let’s say that this person invests the $10,000 and earns $700. Well, they have to pay taxes on that. Let’s say that they have to pay $200 in taxes on the $700 gain so they end up netting only $500 after taxes. But if they were to pay back that debt, there are no taxes owed. They get that return back TAX-FREE, an IMMEDIATE, RISK-FREE, TAX-FREE 7% return by paying back that debt.

Also think about it if this were you.  How great would it feel if you had this extra $10,000 and you used it to wipe away the debt, to get rid of it all together? How great would that feel?

So by paying debt, we get an IMMEDIATE, RISK-FREE, TAX-FREE rate of return PLUS it feels good to pay back that debt, right?

All things being equal, if we were to pay back debt that had a 5% interest rate or invest and earn a 5% return, or if we paid back debt at 10% or invested to earn a 10% return, it’s the SAME THING.

So all things being equal, I prefer to pay back debt. Now I don’t know your exact financial situation, so you have to make the call that’s best for you, but I prefer paying back debt especially if it gets to that 5, 6, 7% interest rate or higher, because I’m getting that IMMEDIATE, RISK-FREE, TAX-FREE rate of return on my money.

So thanks for joining me this week, I can’t wait to talk to you and dive into another subject next week, if you have any questions, reach out to me and let me know what else you’d like to cover. I’d be happy to hear from you.

Thanks so much, and we’ll talk to you next week!

Register HERE for a FREE webinar replay where I take a deeper dive on this topic including Q&A.

Rob Bertman, CFA, CFP
Founder & CEO
Money With Impact
www.moneywithimpact.com

 

Cut your spending by $6,000 without giving up the fun and without a complicated budget.

Break the paycheck-to-paycheck cycle, find the money to pay back your loans and finally build your savings.