Should I Pay Off Low-Interest Debt or Invest?

This week, The Simple Dollar attempts to address challenging questions in personal finance by looking at both sides of the story and figuring out some of the factors you need to look at to make a decision.

Most homeowners are in the process of paying off a large mortgage, one which requires a large payment each month, and the majority of those mortgages are at a fairly low fixed interest rate (yes, regardless of the hullabaloo about subprime mortgages, the majority of mortgages are fixed-rate long term ones). Often people earn substantially more than they once did and can either begin investing the money or begin making extra payments towards their mortgage.

Which is the right path? This isn’t just a question of numbers, but also a question of goals and philosophy. Let’s take a look at both sides of the equation.

Debt Freedom!

Debt freedom is a spectacular feeling. Suddenly, you’re no longer encumbered with a large mortgage payment each month and your monthly budget suddenly shrinks greatly. Many more lifestyle opportunities open up to you – you can switch to a lower-paying but more fulfilling job, or perhaps even make the leap and become self-employed.

Paying ahead on your mortgage isn’t just a monetary investment – it’s a psychological investment, too. Watching that balance falling brings about a sense of purpose and a sense of peace – your monthly financial burdens are slowly disappearing and soon you’ll be free of the burden of your mortgage.

Even if you look at it strictly as an investment, it’s not too bad. If you have a 6% home mortgage, payments towards that mortgage will earn 6% – guaranteed. No worrying about ups and downs in the stock market, no worrying about anything else – a guaranteed 6% return, which you’ll effectively receive when your mortgage is paid off.

Invest For Your Dreams!

It’s a simple comparison. Over the last thirty years, the Vanguard 500 index fund has returned, on average, over 12% per year. A home mortgage is thirty years long. Thus, unless your home mortgage is 12% or close to it, you’re better off dumping your excess cash into that index fund.

That’s not to say that there won’t be individual years where putting money in the home mortgage won’t be a better investment – there sure will be. But a long-term commitment to investing instead of paying off a low-interest debt will give you more money (provided, of course, the next thirty years of the S&P 500 grow like the last thirty).

We’re not looking at a short term window here – if you’re looking at just a few years, the debt repayment is probably a better investment because of the volatility of stocks. But if you’re looking to be cash ahead many years down the road, money in the Vanguard 500 – or a similar broad-based low cost index fund – will come out on top of money in the mortgage every time.

My Take

To me, this debate comes down to goals. What are your goals? If your goals don’t require a large bankroll – for example, if you dream of being self-employed or only working part time so you can be involved with volunteer work – you can likely achieve them much sooner by putting money into the mortgage than into an investment vehicle. However, if your dreams center around expensive items, like a large dream home or grand vacations or similar things, you’re probably better off in the investment vehicle.

For our situation, a direct route to debt freedom is the better choice for now. We’re looking at the strong possibility of another child, and if we choose to do that, one of us will likely become a stay-at-home parent. That means that eliminating debt now means lower monthly bills when that time comes, making the financial situation that much more tenable.

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