stormchaser
Well-Known Member
How do you guys treat loan payments? I was talking to some investors and they were mixed on how they treated payments. Some said pay them off as quickly as possible and others said if you were sub 3.5% interest to pay the minimum plus a very small amount because investments will out pace the interest.
Certainly a valid point. However, there is more than meets the eye on this one.
The argument simply states that if I can make a higher return on an investment than the interest rate on my loan, then it's better to invest. Frankly, it's simple math...hard to argue. For example, for simplicity's sake, let's say I have a $100 loan from you at 3.5% interest. I pay you $100, but I still owe you $3.50 after that payment because you took interest out. The argument says, though, that my friend Billy will pay me a 4% return on my $100. So rather than pay off the loan, I invest with Billy and make $104! I take the $4, pay the $3.50 in interest to you, and make 50 cents by NOT paying off the loan! Add a few zeroes on to the end of those numbers here, and that's what this discussion is all about.
But just a word of caution for one important reason: taxes.
I understand that one can argue that taxes aren't paid until a sale of stocks, and I get that. But for the sake of this discussion, we are needing to compare at the end of the year whether it's best to have a loan or invest (the whole start of this thread). My investment has to do better than my loan for me to keep the loan, right? Well, we have to sell to pay that interest...and selling=taxes!
Ok, the problem is...oddly enough...math.
I would have to have a 4.375% annual return on my investment in order to simply EQUAL paying off my 3.5% loan!
If I had a $100,000 loan at 3.5% interest, I would pay $3500/year in interest. If I paid off the loan, I would make a guaranteed 3.5% return. GUARANTEED. (***Paying off a loan is making the equivalent return of the interest rate***). If I kept the loan, however, and invested, I would have to make 4.375% just to break even! $4375 profit at 20% in capital gains tax=$875. I pay the government $875, then take the amount left over which is you guessed it...$3500! I cover my loan and simply break even by having a higher return.
It's only AFTER 4.375% that I start making money, not 3.5%. You must consider this.