In this episode, Dr. Matt Motil talks about whether or not you should pay off your debt or invest extra cash.
The right answer is “it depends”
First off, I’m not an accountant or CPA, so make sure you check with a professional before implementing any of this advice.
Let’s get started…
To Pay Off Debt Or Invest Extra Cash
1. Black And White Economics
There are some emotions that can creep in when it comes to this topic, so let me start out by saying that when that happens, all bets are off on logical thinking sometimes.
The thought process here is that if I pay off my debt, I can use that money that I was spending each month on payments to invest – in theory, investing more, faster.
The goal is when you are choosing to pay off your debt or invest extra cash; you would invest extra cash in real estate and/or another passive income stream.
So let’s say if all your bad debt (credit cards, car loans, etc.) added up to $3,000/month.
Over a 12 month period that would be $36,000 a year of debt service.
In theory, say you didn’t have those “bad” debts you would have $36,000 that year to invest in something.
2. Bad Debts
Credit cards, car loans, student loans, home mortgage, etc.
There is good debt and there is bad debt, not all debt is created equal.
If the debt earns you money and if it earns you more money at a higher rate than it costs you, that is considered “good” debt.
Say if you take out a loan on an investment property paying at 5% interest rate, but the property is earning a 10% return…
Then you have a net income of a 5% return overall.
You need to be smart with debt.
You don’t want to be upside down on your debt.
Say you borrow money at a 12% rate and the property earns an 8% return then you are losing money.
You don’t want to borrow more money than the asset is worth.
Bad debt is anything that doesn’t earn you money.
Bad debt can become good debt if you turn your primary residence into a rental.
When making a decision, “do I pay off my debt or invest” ask yourself this simple question: “will my investments make more than the debt service on my loans?”
3. Credit Card Debt Example…
Say you get $10,000 back in your income tax return.
You have $10,000 in credit card debt.
It’s at 29% interest rate.
You could pay this off or you could invest $10,000 instead.
If your investments aren’t going to make you more than 29%, it’s not smart to invest and you should pay off you debt first.
4. Car Loan Example…
You have $30,000 left on your car loan at 2.9%, but would like to invest in real estate that would get you 10%.
If you took the $30,000 and earned 10% simple interest, you’d be looking at $250/month.
You could take that $250/month and put it towards the balance on the car loan.
The net difference here is 7% gain overall on your money, kind of – because you were paying on the car loan anyway!
In this scenario, you could take that passive income and put an additional $3,000 per year towards paying off the car.
So you have the investment, AND are working towards paying down debt at the same time.
5. Should You Pay Off Your Primary Home Mortgage Or Invest?
Here’s a few reasons why I personally don’t like this…
- Your home mortgage is low interest – its hard to earn more
- Unless you refinance, your payments don’t change – YES you can pay off faster and YES you can save on interest BUT that’s on the assumption your home stays at the same value and/or increases
- The money is locked up in the home unless you restructure the asset to pull it back out – so you either have to go to the bank and get a line of credit, refinance and cash out, or sell the home to pull out equity
All that said, emotions can be involved and then all bets are off. If you really want to have no home mortgage, and that’s a personal or family goal to make you sleep well at night, then OK.
I understand it is less pressure if the house is paid off and you lose your job.
The index fund is a great option!
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