People are often faced with the difficult choice of how they should use their money, whether it be choosing between investing, paying down debt early, or deciding which debt to pay down first. For these questions, one needs to look at what you’re missing out on by choosing one option over the other. As we will discover, it is much easier to choose which debt to pay down first than it is to decide whether to invest or pay down debt early.
When deciding to pay down debt early, the logic goes “If I can earn a return on my money by investing, why would I want to pay off my debt early?” It is true that paying down debt prematurely, beyond what your payment schedule requires, may not always be in your best interest. The answer to whether or not it is beneficial lies in the opportunity cost. Opportunity cost examines what you miss out on when you pick one decision over the other.
To think about opportunity cost we will explore an example. Imagine you have a student loan with a 7% interest rate. You are caught up on your payments and have $1,000 that you could use to pay down the balance early. You could also use that same $1,000 to invest in your personal investment account. If the money is used to pay down the loan, you will save 7% per year on the principal you paid down. At the same time, the long term expected market return is around 10% for an investment in the S&P 500. Taken at face value, it would seem as though the obvious choice would be to invest in the market and earn 10%, rather than pay down something that saves you 7%. The problem is that the 10% return on the market is an assumption based on historic returns and doesn’t take into account where we are in the market cycle, tax implications of capital gains, or your individual investment allocation. Being that we are late in the market cycle and traditional investment returns over the next few years are likely well below 7%, now would be a smart time to be putting that money towards paying down loan balance with interest rates above 7%. As you can see, it is a much more complicated decision when one begins to consider all these different implications.
As you can see, there are difficult assumptions to make in order to determine the answer of investing versus paying down debt early. While it is complicated to apply this principle to unknowns like investment returns, it can easily be used in prioritizing where your money goes amongst your monthly expenses because you know the rates that you will be charged.
When it comes to expenses, your credit card bill is almost always going to charge the highest interest rate. The same principles of compound interest that you can use to grow your wealth can also work against you to create a mountain of debt. One missed payment can begin the snowball effect, growing the amount you owe every month making it less and less affordable. Prioritizing credit card debt over other bills can help prevent the debt from piling up. Similarly, other types of debt that charge compounding interest expense should be prioritized to pay down on time in order to prevent the debt from compounding out of control.
When considering whether or not to pay down debt early, there are a lot of unknowns to contend with. Ultimately, the peace of mind you gain from taking the sure thing and paying down your debt early can leave you with less of a burden than dealing with the risk of investing in the market. When choosing between bills, prioritize paying down the debt with the highest interest rate to prevent debt from snowballing out of control.
By applying the principles of opportunity cost to each decision you make with your money, it can help you make smarter choices and strengthen your financial position.