When you have extra money, what is the best strategy? Should you pay down a loan or invest in your portfolio? The answer depends on several factors.
To decide whether paying down debt is more valuable than investing, compare the loan interest rate with the investment’s expected return. If the expected investment return is higher, investing may offer greater financial benefit. If the loan interest rate is higher, paying down the balance may be the better use of your excess cash.
Loan Interest vs Potential Investment Gains
First consider the interest rates for the loans you have outstanding, recognizing that interest rates can vary widely. Credit card debt, for example, often carries interest rates of 20% to 25% or more, while federal student loans currently sit at 6.52%. Depending on the year of purchase and the borrower’s credit, auto loans and mortgages may carry low interest rates. In 2021, the average weekly mortgage rate was as low as 2.65%.
Next consider what potential return you can expect if you choose to invest rather than pay down debt. The comparison is not entirely straightforward because investment returns are uncertain. The S&P 500 was up 31.49% in 2019 and down 18.11% in 2022. This was all in the past 8 years! To set your expectation regarding potential investment returns, consider the return you are currently receiving on your investments.
Peace of Mind
Before deciding what to do with your excess cash, ask yourself how you feel about being in debt. If you are uncomfortable with outstanding loans, this may mean paying off debt is the appropriate decision for you. Outside of high-interest debt like credit cards, which generally should be paid down before investing, the choice may depend more on your personal preference. However, if manageable debt doesn't concern you and you prioritize potential investment growth, investing may be more appealing.
What this means is that the best financial decision may not be the one you are most comfortable with. If the interest rate is very low, aggressively paying down that debt may carry substantial opportunity cost. For example, if you have a 3% loan rate but are personally debt-averse and decide to pay down debt instead of investing excess cash flow, you may be negatively impacting your future personal wealth. The more financially sound decision would be to maintain a low interest loan and invest in a portfolio with historical returns higher than the loan interest rate.
Understanding the math is important, but it is equally important to understand yourself. If a decision has a minor financial impact but a major psychological one, notice that and weigh it appropriately.
Summary
Deciding to use excess cash to pay down debt or to increase your investment portfolio is a wonderful problem to have! Your decision can impact both your current and future financial wellbeing. Doing the comparison of debt interest rates to potential investment returns will provide a starting point. Then consider your personal comfort level with the total amount of loans outstanding.
The right choice for you may be different for someone else. If you are unsure on the correct strategy for you, reach out to a trusted financial advisor, who can guide you through your options and help you make the right decision.
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The material has been gathered from sources believed to be reliable, however Bedel Financial Consulting, Inc. cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. To determine which investments or planning strategies may be appropriate for you, consult your financial advisor or other industry professional prior to investing or implementing a planning strategy. This article is not intended to provide investment, tax or legal advice, and nothing contained in these materials should be taken as such. Investment Advisory services are offered through Bedel Financial Consulting, Inc. Advisory services are only offered where Bedel Financial Consulting, Inc. and its representatives are properly licensed or exempt from licensure. No advice may be rendered unless a client agreement is in place.
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