Pay Down Debt vs. Investing

I'm sure this discussion has come up before however I performed a search and couldn't get any meaningful discussion.

Does anyone have a way of caluclating whether one should pay down their debt or invest?

At a glance I feel like anyone with a mortgage who is paying 7% interest should simply pay down their debt as its equivalent to an after tax return of 10-13% (depending on tax bracket, and im sure other factors etc).

I can't think of many investments which return 10-13% so therefore paying down your debt always wins?

This being said its obviously far more complicated than that due to things like capital growth and income which one can earn.

I guess an example would be an investment property which slowly appreicates in capital value as well as gradually gaining more and more income each year (increase rent)

Can someone point me in the right direction or is it really as simple as calculating your cost of debt (a) and comparing it with your investment return (b) and unless b>a you pay down debt.

Re: Pay Down Debt vs Invest

kid hustlr said:

Can someone point me in the right direction or is it really as simple as calculating your cost of debt (a) and comparing it with your investment return (b) and unless b>a you pay down debt.

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No need to complicate things.

Unless you can earn more after tax than that 10 - 13% 'return' you would make by paying off your debt, then yes, you are better paying off your debt.

Re: Pay Down Debt vs Invest

So the effect of a compounding return (like capital value increasing at say 5% each year or earning rent which steadily increase over time) doesnt, at some point overtake the fixed, consisten repayments of a loan?

I guess what I'm saying is although in year 1 you may be paying off your debt, in year 20 because of the compounding effect you would have been better off to invest?

Re: Pay Down Debt vs Invest

kid hustlr said:

I can't think of many investments which return 10-13% so therefore paying down your debt always wins?

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We had the same dilemma in the early 90's when we were paying off our mortgage. In the end we decided to hit the mortgage with everything we had and stand by on other investments, 4 years later the house was paid off and the pressure was off. Best decision we ever made.

Re: Pay Down Debt vs Invest

kid hustlr said:

So the effect of a compounding return (like capital value increasing at say 5% each year or earning rent which steadily increase over time) doesnt, at some point overtake the fixed, consisten repayments of a loan?

I guess what I'm saying is although in year 1 you may be paying off your debt, in year 20 because of the compounding effect you would have been better off to invest?

Click to expand...

If you have a mortgage at 7% you cant beat paying off debt as it is very hard to get 10-13% return annually ... and the compounding effect works for paying off debt as well not just for investment... say you paying off a mortgage and the property increase in value, reward you a tax free status return ...

also paying off mortgage is a guarantee return, there is no other investment that offer this assurance...every dollar you paid off you get 7% after tax Guarantee return.

Triple AAA government bond offers you half of that return

Re: Pay Down Debt vs Invest

Bill M said:

, 4 years later the house was paid off and the pressure was off. Best decision we ever made.

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It's a great thing to live in a paid for house, When I made my last deposit into my home loan account I took my shoes of and walked through the back yard, The grass felt so much better once it was paid for

Once your house is paid for, Then your income is really freed up and you'll have major fire power to start an investment plan, And if you spent the time learning about investing while you paid of your debt, you'll be alot smarter about it.

Re: Pay Down Debt vs Invest

kid hustlr said:

So the effect of a compounding return (like capital value increasing at say 5% each year or earning rent which steadily increase over time) doesnt, at some point overtake the fixed, consisten repayments of a loan?

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As Roe said, as you pay of your debt the compounding affect is still working in your favour,

Each months payments will contain less interest as the loan decreases and more and more priciple will be extingished, so the affect is the loan reduces at a faster and faster rate.

eg. in month 1 a payment of $1000 may only reduce the loan by $150 because you had to pay $850 in interest, But by month 120 you still pay $1000 but you may pay $900 0ff your loan because now the loan is so much smaller and there is only $100 interest.

Re: Pay Down Debt vs Invest

ROE said:

If you have a mortgage at 7% you cant beat paying off debt as it is very hard to get 10-13% return annually ... and the compounding effect works for paying off debt as well not just for investment... say you paying off a mortgage and the property increase in value, reward you a tax free status return ...

also paying off mortgage is a guarantee return, there is no other investment that offer this assurance...every dollar you paid off you get 7% after tax Guarantee return.

Triple AAA government bond offers you half of that return

Click to expand...

I think the bolded portion is the aspect I'm not taking into account. I guess I hear stories of all these people with high debt levels, a great number of investment properties who never paid off their PPOR mortgage etc etc who have done well but the fact of the matter is it has been on the back of very high nominal capital returns, not the compounding effect of steadily increasing rents and cap value

Re: Pay Down Debt vs Invest

kid hustlr said:

I think the bolded portion is the aspect I'm not taking into account. I guess I hear stories of all these people with high debt levels, a great number of investment properties who never paid off their PPOR mortgage etc etc who have done well but the fact of the matter is it has been on the back of very high nominal capital returns, not the compounding effect of steadily increasing rents and cap value

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Yeah,

In my veiw it's not "Good debt and Bad debt"

It's "Bad debt and Worse Debt"

The high debt model works great 95years out of 100 years, But in the years it doesn't work it will completely wipe you out, Look and the big failures of recent years.

Prudence pays.

Drill it into me one more time.

Let's use an example.

I buy a property in year 1 which is exactly neutrally geared instead of paying the mortgage. Obviously in year 1 from a nominal perspective i make a 'loss' when compared to just paying down the mortgage.

Yet in year 2 the property appreciates a little in value and i also up the rent by say 3%. This year the return I receive for that investment is still going to be less than paying down the mortgage, but by a slightly reduced amount?

Continue forward to year 20 where the property value is now much much larger and the rent payments are so large that its actually a very strongly position +ve cashflow property. In this year is it not feasible that the return could be much much larger than simply paying down the mortgage?

Does this make sense at all or am I dribbling?

kid hustlr said:

Drill it into me one more time.

Let's use an example.

I buy a property in year 1 which is exactly neutrally geared instead of paying the mortgage. Obviously in year 1 from a nominal perspective i make a 'loss' when compared to just paying down the mortgage.

Yet in year 2 the property appreciates a little in value and i also up the rent by say 3%. This year the return I receive for that investment is still going to be less than paying down the mortgage, but by a slightly reduced amount?

Continue forward to year 20 where the property value is now much much larger and the rent payments are so large that its actually a very strongly position +ve cashflow property. In this year is it not feasible that the return could be much much larger than simply paying down the mortgage?

Does this make sense at all or am I dribbling?

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I am not quite sure what you mean,

Are you saying that rather than make extra payments off your existing mortgage, you use those extra funds to buy an investment property,

Eg, Instead of paying $10K off the existing property you use those funds to pay the stamp duty, legal fees and loan app fees to buy a second property, which also happens to be neutrally geared from then on.



In that case, Rather than having $10,000 earning say 7% compounded tax free, risk free off your existing mortgage, you now have $10,000 invested technically earning nothing, and you have taken on alot more risk,

You will have tenant risk, market risk, interest rate risk, and risk that your circumstances may change.

As you pointed out though, There could also be substanial return if every thing goes well, But that is not a "free" return. Any extra return over and above the risk free 7% you could have got else where is payment for taking the extra risk.

If Here's the thing though with this stratergy, when things go in your favour, you may beable to earn very large returns, But if the wheels fall off, you may suffer substanial losses,

As a once off stratergy when the time is ripe for it you will do very well, But if you stratergy is to constantly contiune to leverage up over the years, eventually the wheels fall of and you will lose your entire net worth.

Thank you for the replies Tyson.

I recognise that higher debt = higher risk.

I also recognise that a deicsion to invest should be weighed up against the opportunity cost. In this case we are comparing the return we get from paying off the 7% mortgage (anywhere between 10-13%, depending on your tax level) vs the return we can get from investing.

Let me try another example.

We get a 10k bonus from work. rather than pay 10k extra off the mortgage, I invest in the initial ABC IPO.

In year 1 ABC makes no profits and the capital value does not change. At this point we would have been better off paying off the mortgage.

In year 2 ABC makes some profits and our capital value is now 10.2k and we receive a small dividend of $50. Once again the return we receive in this year is less than us simply paying off the mortgage.

ABC continues to grow and steadily over time the dividend becomes larger and larger.

In year 20 the capital value is now 10k and we now receive a very strong divided, amounting to 1.5k or 20% of our initial outlay. At this point the return we are receiving is far far greater than the 7% we could receive by paying off debt.

A little bit of a farfetched example but I guess I'm trying to draw the comparison at how an interest only loan has the same level of payments each year, therefore 'the time value of money' cost is actually decreasing over time, whereas if we invest in an asset which will continue to grow and provide larger cashflow year after year (rent payments?) at some point in time way down the future the decision to invest 'back in the day' will prove to be a good one.

kid hustlr said:

Let me try another example.

We get a 10k bonus from work. rather than pay 10k extra off the mortgage, I invest in the initial ABC IPO.

In year 1 ABC makes no profits and the capital value does not change. At this point we would have been better off paying off the mortgage.

In year 2 ABC makes some profits and our capital value is now 10.2k and we receive a small dividend of $50. Once again the return we receive in this year is less than us simply paying off the mortgage.

ABC continues to grow and steadily over time the dividend becomes larger and larger.

In year 20 the capital value is now 10k and we now receive a very strong divided, amounting to 1.5k or 20% of our initial outlay. At this point the return we are receiving is far far greater than the 7% we could receive by paying off debt.

A little bit of a farfetched example but I guess I'm trying to draw the comparison at how an interest only loan has the same level of payments each year, therefore 'the time value of money' cost is actually decreasing over time, whereas if we invest in an asset which will continue to grow and provide larger cashflow year after year (rent payments?) at some point in time way down the future the decision to invest 'back in the day' will prove to be a good one.

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The $10K that you put against your home loan compounds also,

By year 20 your $10K would be worth $37,203 (initial $10,000 + $17,203 of compounded interest savings) and it would be generating $2,689 per year in interest.

Either way it all comes back to the fact that the alternative investment must have a low risk return in excess of 9.1% to beat the home loan allocation.

Offcourse it is entirely possible for you to allocate funds in a way that can beat the risk free return, However this takes alot of skill and knowledge to do it is a way that is not gambling and is genuinely low risk.

In my veiw I think paying of the homeloan while you take the time to learn about investing in companies would be the way to go, Other wise the ABC company you spoke of might turn out to be ABC learning centres and worth nothing by year 5.

When I was typing ABC i was chuckling to myself, I'm glad you picked up on that.

Appreciate the assistance Tyson.

kid hustlr said:

Thank you for the replies Tyson.

I recognise that higher debt = higher risk.

I also recognise that a deicsion to invest should be weighed up against the opportunity cost. In this case we are comparing the return we get from paying off the 7% mortgage (anywhere between 10-13%, depending on your tax level) vs the return we can get from investing.

Let me try another example.

We get a 10k bonus from work. rather than pay 10k extra off the mortgage, I invest in the initial ABC IPO.

In year 1 ABC makes no profits and the capital value does not change. At this point we would have been better off paying off the mortgage.

In year 2 ABC makes some profits and our capital value is now 10.2k and we receive a small dividend of $50. Once again the return we receive in this year is less than us simply paying off the mortgage.

ABC continues to grow and steadily over time the dividend becomes larger and larger.

In year 20 the capital value is now 10k and we now receive a very strong divided, amounting to 1.5k or 20% of our initial outlay. At this point the return we are receiving is far far greater than the 7% we could receive by paying off debt.

A little bit of a farfetched example but I guess I'm trying to draw the comparison at how an interest only loan has the same level of payments each year, therefore 'the time value of money' cost is actually decreasing over time, whereas if we invest in an asset which will continue to grow and provide larger cashflow year after year (rent payments?) at some point in time way down the future the decision to invest 'back in the day' will prove to be a good one.

Click to expand...

You are assuming your asset always appreciate in value, and increase in dividend payment..

there is no guarantee of that and when it comes to people chasing an extra few percentage point, there are far more money loss in this venture than money losing at gun point.

go to any adviser and they can draw you a pretty diagram and tell you why you should not pay off debt but load up debt and invest, their diagram only works one way, that is stuff going up.

Turn it around and predict stuff going backward for a decade and see what happen when you have large pile of debt..this looks worse than hell....

Also their diagram works on average compounding rate so it looks very very good..
but in real life it's a zig zag and when it comes to compounding zig zag isn't very pretty.

actually most people failed to see this that why they never have enough for retirement
because those wonderful diagram show how much they have at the end of their working life because of that magic average compounding number..

here is something you can do ... take ABC or XXX stock ..year one gone up 10%, year 2 gone up 15% year three backward 15% what is your total return?
7% over three years on initial investment ....does that look pretty?

Where as if you don't even count compounding, and get a guarantee 7% a year
paying off the mortgage, that's 24% over three years....and the longer this goes on you are way a head...

this logic also applied in the internet bubble days...they discard stocks like coke and
McDonald claiming well internet stocks has higher earning potential and the sky is the limit for these stocks....eventually they will earn far more money than coke and McDonald... Let put it to a simple maths logic.

Coke those days make around a billion dollar profit a year but yahoo worth as much as coke and make bugger all money, so for every year yahoo don't make profit Coke is 1

Billion a head and the longer this goes on the harder and harder for yahoo to catch up
do yahoo make a billion profit a year these days even after 12 years?, not even close
and so yahoo pretty much lost the race forever because they are some 20B profit behind coke , yahoo probably wont even make 20B in its life time...

Coke now make 2-3B profit a year....

The take away? dont compare pie in the sky number for a guarantee return

kid hustlr said:

I'm sure this discussion has come up before however I performed a search and couldn't get any meaningful discussion.

Does anyone have a way of caluclating whether one should pay down their debt or invest?

At a glance I feel like anyone with a mortgage who is paying 7% interest should simply pay down their debt as its equivalent to an after tax return of 10-13% (depending on tax bracket, and im sure other factors etc).

I can't think of many investments which return 10-13% so therefore paying down your debt always wins?

This being said its obviously far more complicated than that due to things like capital growth and income which one can earn.

I guess an example would be an investment property which slowly appreicates in capital value as well as gradually gaining more and more income each year (increase rent)

Can someone point me in the right direction or is it really as simple as calculating your cost of debt (a) and comparing it with your investment return (b) and unless b>a you pay down debt.

Click to expand...

There is one thing that you've omitted from your deliberations: inflation. Although we're currently in a low-inflation environment, there can be no guarantee that in the future, inflation will not increase beyond the RBA target range. In any event, inflation eats away at the real purchasing power of your liquid assets, so any return on your investment needs to be considered in an after-tax, after-inflation scenario.

Re: Pay Down Debt vs Invest

ROE said:

... say you paying off a mortgage and the property increase in value, reward you a tax free status return ...

Click to expand...

Yes, but it is all relative. The house that will be bought next will have also increased in value by the same percentage over the journey, give or take, as the one just paid for. That is why it is silly to count on your own home as an investment - there is no need to get all warm and fuzzy if it has gone up in value by $300k by the time you sell it if the house you want to buy next has also increased by at least as much and is still as much out of reach!!! By all means pay it off as early as possible because it will always put you in a better position down the track, but don't forget to have a life in the meantime, and if you can afford it, invest a dribble in shares or whatever every now and then too.

kid hustlr, can you maybe afford to pay an extra $50 a fortnight off the mortgage, and then use any lump sums that come your way, such as your tax return, to buy shares?

Re: Pay Down Debt vs Invest

kid hustlr said:

So the effect of a compounding return (like capital value increasing at say 5% each year or earning rent which steadily increase over time) doesnt, at some point overtake the fixed, consisten repayments of a loan?

I guess what I'm saying is although in year 1 you may be paying off your debt, in year 20 because of the compounding effect you would have been better off to invest?

Click to expand...

Paying off debt also results in compounding via the interest saved.

Another thing to consider is the "sleep at night factor". Repayment of debt is absolutely a low risk option and it's not easy to beat the after tax return you'll make by doing so for the average investor.

The reduction in overall stress, simply because I don't have to worry about paying off a mortgage, is worth a lot in itself. No more worries about interest rates going up. Even if you lose your job and have to take a lower paying one somewhere else it's not going to be a disaster if you actually own your residence. A lot less stress.

Re: Pay Down Debt vs Invest

Eager said:

That is why it is silly to count on your own home as an investment -

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This comment needs addressing, it is an investment. Your own home is the biggest investment you will ever make for your future. There is nothing like paying no mortgage or no rent, believe me I am there, totally rent/mortgage free. It has enabled me to retire early, of course it is an investment because I don't have to pay for any accommodation at all (apart from running costs). It means all extra monies earned is available for other investments. Further more your own home is totally capital gains tax free, you can keep trading up until you retire and get rid of the kids. Then you can downsize and pocket large sums from the sale of your family home tax free (i have done this), surely that's worth something.

To kid hustlr, mate I've been where you are now and as others have mentioned there are no guarantees in life. Just imagine if you were to go down the investing in shares path back in November 2007, you would have suffered a 40% capital loss until now. Also I have investment property, right now prices are stagnating, some are predicting prices even going lower. How long can you sit out a downturn? Shares have gone nowhere in 7 years! Link here for that. My opinion is to clear that rotten mortgage ASAP, right now nothing is beating that 13% quoted and there are no guarantees anything will for some time to come yet, cheers.

Re: Pay Down Debt vs Invest

Bill M said:

This comment needs addressing, it is an investment. Your own home is the biggest investment you will ever make for your future. There is nothing like paying no mortgage or no rent, believe me I am there, totally rent/mortgage free. It has enabled me to retire early, of course it is an investment because I don't have to pay for any accommodation at all (apart from running costs). It means all extra monies earned is available for other investments. Further more your own home is totally capital gains tax free, you can keep trading up until you retire and get rid of the kids. Then you can downsize and pocket large sums from the sale of your family home tax free (i have done this), surely that's worth something.

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Yes, I hear you. But the house itself is not an investment vehicle first and foremost. It is primarily a roof over your head, and at the end of the day, if you were to happily remain in your modest first home once it was paid off, it doesn't matter at all if it never appreciates in value.

Trading up is something that most of us do however, me included. But it normally results in bigger and bigger loans!