Paying interest works against you in the same way the earning interest works for you. Of this, I am certain. However, as you can see in my October 2010 Balance Sheet, I have $10k in my investment account that could be used to pay down some of my student $43k in student debt. Whether you’re carrying credit card debt, student loan debt or a home mortgage, you’ve likely wondered whether you should invest money that you have or pay off your debt. The way I see it, this decision has two aspects: emotional and mathematical.
Emotionally, debt is a drain. It’s constantly on your mind and it impacts your emotional well-being. Many people who become debt-free talk about the burden that was removed once the debt was paid off. Because the decision to pay or not pay off your debt has emotional implications, some of the decision should be based on your personal feelings. If your debt makes you feel trapped, you may opt to pay off the debt even if it’s has a low rate and you can make a better return elsewhere. I think that your emotions should factor into your decision, but you shouldn’t allow them to dictate your selection.
More importantly, though, you should consider the math of paying off your debt. This comes down a comparison between the after-tax interest being paid on the debt and the after-tax rate of return you could expect to earn on that money. Once you have both of these rates calculated, you can make a decision. Basically, you should pay down your debt if the after-tax interest that you pay on the loan is higher than the after-tax rate you can earn on a bond investment with an equal duration. The reason for using a bond investment for this comparison is that when determining whether to invest or pay off your debt, you need to ensure that you’re comparing yields on two investments carrying the same risk. Paying down your debt is the equivalent of a risk-free return equal to the interest rate you’re paying. You can indeed attempt to calculate a risk-adjusted rate, but I personally think that gives you too much room to fudge the numbers.
In my case, the interest rate on my student loans is 5.8% on my $10k and 6.8% on the $33k of parent loans. Since my loans qualify for a tax-deduction, the after-tax rate is about 4.5%. Since I don’t receive the tax benefits of the parent loan, that rate is still 6.8%. Either way, based on current risk-free rates available in the market, the obvious choice appears to be to pay down my debt. However, even though I know where the math points, it’s still something I struggle with. Recently, my investments have been doing well. A simple calculation shows that my investment portfolio is up about 35% over the last 5 months and I don’t want to miss out an any continued recovery in the portfolio. On the other hand, we all know past returns aren’t indicative of future returns. If I do decide to use this $10k to pay down some of my loans now, I need to determine how I want to handle it. Paying down the loan with no tax-benefits makes the most mathematical sense. However, if I factor in the impact on my emotions and personal well-being, I may opt to pay off the loan that it’s in my name completely. I may also opt to do something in-between by splitting the $10k in some form. I’ll keep you posted on what I decide to do.