Is it better to pay off debt or to invest?
A decision we often face is whether to use our money to pay off existing debts or invest it in search of attractive returns. The answer depends on various factors. We’ll explain the key aspects so that you can decide whether, in your specific case, it’s better to pay off debt or invest.
The first thing to consider is that not all debts are bad, although it would be preferable to have none. It may seem obvious, but we are not talking about the same debt when referring to a mortgage as when dealing with consumer credit. The difference lies not only in the purpose but also in the interest rate and the value each brings.
It’s also important to consider our life stage. It’s reasonable to take on debt while young to buy the house that will be our primary residence or to start a business. In both cases, it’s something that can increase our assets or even generate income. On the other hand, it’s not advisable to take out a loan to buy a new TV or even go into debt to buy a car, unless one is clear about the implications and has no other option.
How much debt is too much?
A prerequisite to all of the above is our level of indebtedness. Percentages vary according to experts, but there is some consensus in considering debts that exceed 30% of our income as potentially problematic. The 28/36 rule, for example, states that housing-related expenses – including the mortgage – should not exceed 28% of our income. If we include consumer loans and debts such as car financing, the maximum is 36%.
Another general recommendation is to avoid short-term debt. Financial catastrophes often begin innocently, with small loans or credit card payments. Even if the amount is not very large, this type of debt usually has high-interest rates that can quickly become a big problem. Therefore, it’s advisable to pay off these debts as soon as possible.
The case of revolving credit cards is very illustrative. These cards allow the cardholder to repay the spent credit through monthly installments of the amount chosen by the cardholder, with associated interest, of course. They can be a useful financing tool due to their flexibility, but danger always lurks behind them. A combination of high-interest rates and low installments can be lethal: as financial analyst Natalia de Santiago explains, if the chosen installment does not cover the interest, the debt, far from decreasing with each payment, increases. And thanks to compound interest, it can quickly become a very serious problem for our balance.
Pay off debt or invest: what to do
If we have no short-term debt and have our level of indebtedness under control, we can more calmly examine what to do with our money. The dilemma arises when we accumulate a sum or it “falls from the sky” due to a prize or inheritance: what should we do – pay off debt or invest? The most common situation is that this debt is a mortgage. What should be taken into account?
An important consideration is the loan’s interest: the longer the term, the more interest we will pay. From this, it follows that if we pay off the mortgage and reduce the term, we can save money on interest. Always keep in mind the fees for partial (and total) repayment of our mortgage, as they are an additional cost of the operation.
In Spain, with the French amortization system, much more interest is paid at the beginning of the loan than at the end. Therefore, reducing the term makes more sense if we have only a few years left on the mortgage than if we are approaching maturity. However, if the interest we are paying is low, it might make more sense to invest the money instead of paying off the mortgage.
To know this, we would need to consult the amortization table and see how much interest we could save by reducing the term, and compare that amount with what we could likely get if we invested the money instead of paying off the mortgage.
Imagine you have a €200,000 mortgage for 30 years at a fixed rate of 3%. If you pay the minimum monthly installment of €843, over the life of the mortgage, you will pay €103,555 in interest. If you paid €266 more each month, you would finish paying off the mortgage in 20 years, saving €37,347. However, if you had invested those €266 instead of allocating them to the mortgage in something with an annual return of 4%, over 20 years you would have earned €97,562, which is €60,215 more than you would have saved in mortgage interest…
That said, the recommendation could be: pay off the mortgage if you are in the first ten years of the loan and the interest is high; better to invest if you are young (investment has more time to grow with compound interest) or the interest you pay for your loan is low. The key is to understand that there is no one-size-fits-all answer, and each choice will depend on your unique financial situation and long-term goals.
We hope to have helped you make the decision to pay off debt or invest. If you opt for the latter, Urbanitae can be a good option…
