Investing or paying off debt?

Investing or paying off debt?

This is an age old question. While some will lead you to believe that the answer is a very simple "As long as you can out earn your debt then yes!" it is actually not that straight forward. This specific scenario is something that I will likely be writing about frequently to ensure folks take smart and calculated decisions when it comes to handling their money.

Let's pose the following scenario. Let's say you had no debt and no investments, would you go to the bank and ask for a loan so that you can start investing in the stock market? If the answer is not an immediate "NO!" then we have other issues. 

The biggest problem with the question of "Should I invest or pay off my debt" is that, from a mathematical perspective (depending on your interests rates), the math might superficially show that if you invest instead of paying back your loans you might come up ahead. But it's not that simple.

Let's look at a quick example. 

Let's say John has a car loan with the details as described above and he has been trying to aggressively pay that loan down. But one day when discussing his plan with a friend (let's call the friend bad@money) John is told that since the stock market earns, on average, 7.5% annually and his car loan is 4.5% he could be making an additional 3% on his investment. Bad@money then suggest that he could then use those gains to pay off the loan even faster.

What is often not discussed is that the 4.5% in the car loan is guaranteed while VOO's (Vanguard's S&O 500 ETF) 7.5% is an average. Meaning that you are taking a risk. I would even call it a double risk one from the accumulating interest on your car loan and the other from the money you would loose in the stock market should the market take a dive for a few years.

Chart Gathered from www.barchart.com

I am a big fan of the stock market, and will discuss trading strategies at greater length in future posts, but using the market as a strategy for pay off debt is never a good idea. Just image the hit you would have received had you made this decision right before the Dot-com bubble in the 2000s or the housing bubble in 2008. Though both time the market rebounded it took roughly around 7 years to get back to its original price you would have bought in at. 7 years being the magic number here because that his longer than your car loan term was. 

To sum it all up. Does it mathematically make more sense to invest rather than to pay-off your loans? NO! There is simply too much risk that is not being taken into consideration when one simply subtracts the loan interest and the expected returns from the VOO. To put it another way, I rather take a % that is guaranteed versus one that fluctuates. 

Becoming financially independent is all about taking a lot of little calculated decisions that will lead you to success.