A lot of people have a question about which it makes the most sense to do, either paying off debt they owe or investing the money to try and earn more and paying the debt more slowly.
There are plusses and minuses to both.
There is really only one plus for the investing side. That being that you think you will be able to earn more with your money than the interest rate that you are paying. There is no guarantee this will actually happen, even if your interest rate is very small.
There are quite a few more potential plusses on the side of paying off debt.
Debt often causes what people refer to as a liquidity crisis. They get in real trouble because they need cash to pay off their debts and something happens to their income. The less debt you have, the much less likely you are to get yourself into a liquidity crisis.
Another thing that happens with debt is that your lenders often want to exercise some measure of control over your activities during the time that you owe them money. The more money you owe, the more likely they are to be able to impose some sort of penalty on you as part of the deal.
The organization that more than any other takes away your freedoms is not a terrorist group, it’s your mortgage lender. Your mortgage lender absolutely will restrict your ability to go where you want, when you want, and do what you want. They will charge you a ton of interest to be able to do that too.
In fact, many if not most Americans have a continuous liquidity crisis their entire lives primarily due to their lenders (home, car, credit card, and student loan). They never have any money left over at the end of the month because they owe so much to so many different organizations.
A rather large advantage of paying off debt is that you are able to guarantee yourself a fixed return by doing it. I used to have student loans at 6.3% interest rate. Every payment I made on my student loans was the same thing as me earning at least 6.3% after tax on my investments. That’s a pretty high mark for minimum returns. There isn’t anything else you can do that will guarantee you earn at least 6.3% on your money other than paying off debt with an even higher interest rate. You certainly aren’t guaranteed those kind of returns with stocks.
The only thing you can do with stocks that can surpass that is putting money into a company retirement plan and getting some kind of employer matching contribution. This effect is usually much more powerful than anything else you can possibly do, so just contribute any amount that is matched and start serious discussions with what happens after that is done.
Paying off debt will also raise your credit score, which lenders like. The lower your debt owed, the higher your credit score tends to be, since part of a credit score is based around your total amounts borrowed. Paying off debt will help you get cheaper loans in the future, whereas if you invest and carry larger loans the result is usually worse.
Paying off debt also raises your free cash flow, or the amount of money you have left over at the end of the month once all your bills are paid. This is a very significant effect. When I paid off my Accord, my 520/m payments disappeared. That left a lot more at the end of the month that wasn’t being spent on bills. That, by itself, goes a long way towards preventing me from having a liquidity crisis. All things being equal, it’s best to have a lot of flexibility in how you spend your money and debt goes a long way towards preventing you from having that flexibility.
Another thing paying off debt does is buy you peace of mind. If you have 1 million of investments and 1 million of mortgage debt, you may stay up all night worrying about your investments declining or you may stay up worrying about how you will pay the mortgage if you lose your job. Maybe you alternate those. If you have no investments and no mortgage debt, you don’t have to worry about either thing. At least not nearly as much. A lot of people feel a great weight lifted off their shoulders when they get out of debt because they don’t worry so much.
Another thing that is a plus for paying off debt is that returns from paying off debt are actually pretty good. A lot of investment professionals right now are talking about zero real returns from investing in stocks and bonds. Not losing 3.5% or 6.3% or something is better than a lot of eventualities that are being talked about right now.