Paying down loans versus investing

Viewing it as an investment choice
If you have money that you could invest, but you also have a loan, you have the option of using the money to pay down the loan instead. Paying down the loan will give you a guaranteed return by reducing your future loan balance, and eventually eliminating future loan payments or giving you more money when the loan is paid off. This is the same benefit that you get from a fixed-income investment such as a bond or CD, which also gives you fixed amounts of money at specific future times.

Therefore, it makes sense to treat paying down a loan like a bond investment, and compare this option to your other investment options.

Peace of Mind
For many investors, the peace of mind from not having a loan is valuable. If you are in that situation, it may be worth paying off a loan at a small additional cost so that the loan will be gone.

Simplicity
Once a loan is paid off, your life is simplified; you need no longer budget money and time to ensure it is paid. You no longer need to worry that an investment made instead of paying it off will lose value. Selling a house with no outstanding mortgage is simpler.

Liquidity
If you use money to pay off a loan and then need money later, you cannot get it back without taking a new loan, probably at a higher interest rate (such as a home-equity loan rather than a first mortgage). Therefore, it is best to build a significant emergency fund before paying down a mortgage, and not to use money for paying down the mortgage that you might need to spend on something else other than buying a new house. (However, if you add money to your Traditional IRA or 401(k) rather than paying down the mortgage, you do not normally gain any liquidity advantage, since you generally cannot withdraw from the Traditional IRA or 401(k) without a penalty until you reach the appropriate age.)

To preserve liquidity, you might create a dedicated "loan payment" fund, invested in municipal or Treasury bonds, which always has money that could be used to pay down the loan.

Discipline
It requires financial discipline to direct money to savings, investment, or early loan payments instead of fun things.

Once you pay off the loan, if you redirect the freed-up loan payment cash flow to increased consumption, you will have no additional savings in the end.

Special Considerations
If you have a student loan and might work for an employer which will forgive the loan (such as a federal or state government), don't pay it down early unless the rate is very high, as you will forfeit that benefit.

Prerequisites
Before deciding to pay extra to retire debt early you should make sure you understand your financial situation. Is your household budget in order? Do you have an emergency fund established, and enough extra cash flow to make a difference in your loans?

Guidelines for making the choice
Usually, you should pay down the loan if the after-tax interest rate on the loan is significantly higher than the after-tax rate you can earn on a comparable bond investment (a low-risk bond investment with duration equal to the time until you will pay off the loan), and you can pay the loan down without any liquidity problems.

Here is the most likely order of priority for investments versus paying off loans; it does depend on the rates, so these examples are based on typical rates which may not be accurate at any specific time.


 * Invest in 401(k) to get maximum employer match (rate may be over 100% in the first year)
 * Pay down credit cards (rate 10-30+%)
 * Pay down non-deductible auto or student loans, or other medium-rate loans (rate 5-8%)
 * Invest in Roth IRA, deductible IRA or decent 401(k) (rate 5% on Treasury bonds)
 * Pay down deductible mortgage or student loans (rate 4% after tax)
 * Invest in taxable account (rate 4% on municipal bonds)
 * Do not pay down subsidized loans as long as subsidy lasts (rate 0-3%)

Why use bond returns for comparison?
While you may have a higher expected return by investing in stocks, or in a mixed stock/bond allocation, rather than in bonds, that return comes with a higher risk. Unless your investments are 100% in stocks, you can choose to take a higher risk whether or not you pay down your loan, because you can sell bonds and buy stock. Therefore, a fair comparison is between paying down the loan and a bond investment with the same risk.

One way to look at the comparison is to consider the following choices.


 * 1. Invest the money with your preferred allocation.
 * 2. Invest the money in bonds.
 * 3. Pay down the loan and move an equal amount of money from bonds to your preferred allocation.
 * 4. Pay down the loan and leave the investments unchanged.

The choice between 3 and 4, while difficult, is one you have already made; you decided how much risk you were willing to take, and chose your stock/bond allocation. And the choice between 1 and 3, or between 2 and 4, is much simpler; if you pay a higher interest rate on the loan than you would by investing in bonds, you will come out ahead by paying down the loan. If you prefer 3 to 1 (higher rate on the loan), then you prefer 4 to 1 also and should pay down the loan. If you prefer 2 to 4 (higher rate on bonds), then you should invest the money according to whichever of 1 or 2 you prefer.

What type of bonds are comparable?
Paying down a fixed-rate loan gives you a guaranteed, zero-risk return, since it reduces an existing liability. Therefore, it should be compared to a bond with no credit risk. If you would be investing the money in an IRA or 401(k), the best comparison is a Treasury bond; if you would be investing in a taxable account, the best comparison is a high-quality municipal bond, which has almost no risk and usually has better after-tax returns. Note that you are generally best off putting stocks in your taxable account and bonds in tax-deferred accounts -- see Principles of Tax-Efficient Fund Placement for more information.

If your loan is at a fixed rate, the proper comparison is to a bond with duration equal to the time it will take you to pay off the loan, because that is how long it will take you to realize the benefit. For example, if you pay an extra $1,000 on your 6% mortgage, the reduced mortgage balance will decrease by 6% a year, compounded annually (but all the gains are taxable). If there are ten years left on your mortgage, you will reduce your final payment by $1791, so your prepayment is effectively a ten-year bond. If there are more than ten years left but you sell then house in ten years, you will get an extra $1791 after the loan is paid off, so it is again a ten-year bond.

If your loan is at a variable rate, the proper comparison is to a short-term bond even if it will take you a long time to pay off the loan, because you will be effectively reinvesting your savings every year at rates tied to short-term rates. For example, if your mortgage rate is 1% above the one-year Treasury bill rate, and you pay off the mortgage in ten years, your pre-tax gain will be 10.5% more than the rate of one-year Treasury bills reinvested for ten years because of compounding, no matter what happens to Treasury rates during the next ten years.

While paying down the loan gives a zero-risk return, you will still face risk from the potential change in value of an asset (such as a house) you purchased with the proceeds of the loan -- but that risk would still exist if you had purchased the asset with cash.

What is the effective rate?
If your loan interest is tax-deductible, the after-tax rate to use for comparison is the actual rate, reduced by a percentage equal to your tax bracket. For example, if your loan is at 6% and you are in a 30% tax bracket, the after-tax rate is 4.2%; reducing the interest by $600 would increase your tax bill by $180. (Even if you would lose the opportunity to itemize deductions if you paid off the whole loan, treat any partial payment as a fully taxable investment, because you have to eliminate the deductible interest first before you can pay off enough to eliminate non-deductible interest.)

If the decision is close
If the decision is close, it is likely to be better to keep the loan. One reason is that you can refinance your loan if interest rates fall, so the effective cost of the loan to you could be slightly less than its interest rate; in contrast, the Treasury cannot refinance its bonds, and most municipal bonds have only limited call provisions. In addition, if the choice is between investing in a 401(k) or IRA and paying down the loan, investing in the 401(k) or IRA will give you more tax-deferred investments, which will remain valuable even after you have paid off the loan.