How do you decide between paying off debt vs investing in it real estate or the market?
A client asked me this exact question last week and I want to share with you the thought process I used to arrive at a good decision. The client has received an end of the year bonus at his job plus they had some additional money in savings. The sum was large enough where both investing and debt payoff were viable options.
The way this question is typically answered is by comparing the cost of the debt (interest rate) to the expected rate of return on the investment. If the rate is rerun on the investment is higher than the interest rate on the debt then you should invest. And vice versa. But is that really true?
Let’s say you have credit card debt at 16% interest. When you make the choice to pay off the credit card debt, your “rate of return” on that move is 16% (same as the interest rate) for as long as the debt would have been outstanding if you hadn’t paid it off.
Even more importantly, that rate of return on paying off debt is GUARANTEED. The moment you paid the debt off, you earned that return. On the other hand, the expected return on the investment is an estimate. An educated estimate if the analysis was done properly but an estimate nevertheless. So, it’s not correct to compare the returns in each move apples to apples. Instead, the expected rate of return on the investment should be adjusted down to account for the possibility that it won’t materialize.
Another benefit of paying off debt (in full) is that it frees up room in your income statement for you to save the payment you used to make toward investment capital in the future.
Not only that but it also frees up borrowing bandwidth for your future investments. Did you know that when you pay off a debt that has a $500 monthly payment, it adds roughly $80,000 to your borrowing capacity whenever you make your next investment purchase?
So, what was my advice to the client:
- Defer investing for a year
- Use your bonus to pay off some credit card debt and the remaining balance on one of the car notes
- AutoTransfer the payments to savings
- Purchase 2 properties next year
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