BetterTrades

What is a better trade-off, investing or paying down debt?

Everyone is taught (or should be taught) to save at a young age. Time is the friend of the investor and as time passes so does the ability to grow ones capital to the amount that is necessary to pay ones future requirements. Whether one is saving for retirement, for college, or for a rainy day, it is the consistent amount put into investments and the return on investment, month after month, year after year that allow people to reach their financial goals.

The rule of thumb for investors is that they should reduce market risk as they age or as the financial liability that is being funded comes due. The reason for this is simple. Investors can risk losing money at the beginning of their investments because time will allow them to recoup losses. If financial losses are incurred, on or near the time that the capital is need for consumption, than the individual no longer has lost the time and ability to recoup those losses. In the past most financial planners have suggested that people in their 20’s allocate almost 100% to equities and then reallocate their funds over time so that they are in fixed income or cash by retirement. Although the returns associated with of fixed income are much lower than equity so are the potential losses when the money is needed to be spent.

So with all the pressure laid on people to save and invest over the years, is it a better trade-off to pay down debt than to invest? The answer to this is almost always a resounding yes.

The reason that paying down debt is usually a better trade-off than investing that same amount of money, is because the interest rate on debt is usually higher than the expected return of an any investment. The reality is that since interest on debt is based on the principal outstanding every dollar paid against debt is equal to investing that money at the interest rate borrowed. For example if someone has a credit card for 20%, they receive a 20% return for every dollar paid back. If instead of paying back the credit card a person invested a dollar at 20%, after a year they would have an additional $0.20 but would also owe an additional $0.20 on the credit card. Since they would not be any better off financially than if they had just paid back the 20% credit card, this demonstrates that paying back the card is equivalent to investing at the same rate.

If one could borrow at less than they could invest at than it would make sense to use someone else’s money to make money. Most corporations do exactly this when they issue corporate bonds. They expect their return on investment to be much higher than their borrowing costs, and get o keep the difference when they are correct. However most corporations have much lower borrowing costs than individuals and so for most people it will be a much better trade-off to pay back their high interest rate loans before investing their extra money.

There is one exception to this rule that is commonly abused by many homeowners. Because of the tax benefit of mortgage interest it is actually possible to borrow money from your home equity, invest it and make a profit. Many people in this country have over leverage their homes in order to access the cheap capital it affords. However as we have seen from the high default rate on mortgages that this relationship doesn’t hold true forever. Many people have lost money in the market and their homes from trying to use their home equity as investment capital.

For those people that have high interest debt it is almost always a better trade-off to use extra money to pay off that debt than to invest in the market. This of course, only relates to the use of extra disposable income and not income traded in the market to generate cash necessary for necessities and current consumption.

• 401K vs IRA
• Broker or Online
• Fundamental or Technical
• Investing or paying down debt?
• Renting vs. Owning
• Savings vs. Credit Union