Pay Off Debt or Invest?
Welcome to the Schmoozeletter Blog. Your source for weekly water cooler wisecracks from the world of finance. If you have an opinion different than mine or a topic you want to hear about, let me know!
This week, we’re talking about:
Pay Off Debt or Invest?
I was perusing Reddit when I found a post that essentially said:
Should I pay off my mortgage
Or
Should I invest?
The age-old question.
And the good folks at Reddit all gave the same wrong answer.
So what is the right answer?
This is...
Pay Off Debt or Invest?
Now, "wrong" is subjective when it comes to opinions...
Lucky for us, this is a matter of fact.
Here is the situation:
This person had a house, about 25 years left on a 6% mortgage, and enough cash to pay it off entirely.
What should they do?
Pay off the house or throw all the cash into an S&P 500 index fund?
Reddit was in agreement.
"Pay off the house!" the Redditors commented repeatedly.
"Being debt-free is the way to go!"
"Whenever you can pay off debt, it is the right call."
"You can't put a price on peace of mind..."
This is incorrect.
You can absolutely put a price on peace of mind. In fact, I'll do it for you right now.
"But Dave, everyone's situation is different. Some people will just sleep better at night knowing they don't have debt. This isn't a one-size-fits-all booksock here."
Wrong.
Those Dave Ramsey disciples are sleeping better because they are ignorant fools. Allow me to enlighten you.
You know what is universal for everyone?
What is exactly the same whether you are a penny-pinching save-a-holic who squirrels away every dollar or whether you are making it rain at Applebee's every night like prime Allen Iverson?
Math.
Dread it. Run from it. The math is the math.
Here is why you are better off not paying off the mortgage and simply investing the money:
Math.
Boom. Done. You've been mathed.
Okay, more specifically, the interest rate on the debt.
They have 25 years left on the mortgage at 6%. You know what the worst 25-year period for the S&P 500 returned?
7.9%.
7.9% > 6%.
Case closed.
But if you are not convinced, we can run through the numbers together.
Scenario 1: Pay Off The Debt
Let's say this mortgage is $400k. You have $400k in cash. Boom. House paid off. Yay!
But not only that, you are still thinking about the future. You are going to take the mortgage payments you would have been paying to the bank and invest!
Instead of shelling out $2,577 a month, you are now dumping that money into an S&P 500 index fund.
You are an investing genius!
Let's say we get the worst 25-year rate of return in history of 7.9% annualized.
If you consistently put every would-be mortgage payment into the S&P 500, after 25 years you would have:
$2.3 million!
So to recap Team Pay Off The Debt:
25-Year Total:
Paid-off house +$2.3M
That is going to be hard to beat.
Scenario 2: Invest
Let's say this mortgage is $400k. You have $400k in cash. You dump it in the S&P 500.
You are bogged down by the hefty mortgage payment every month, so you don't invest another dime for 25 years.
Again, we assume we get the worst 25-year rate of return in history of 7.9% annualized.
That lump sum would grow to:
$2.7 million!
So to recap Team Invest:
25-Year Total:
Paid-off house +$2.7M
If you are keeping score at home, the price of your "peace of mind" cost about $400,000.
"But Dave, you can't predict the future! You don't know what rate the S&P 500 will get."
Exactly. This was the worst-case scenario! This was the worst rate we've ever seen with the huge stock market crash of 1929 and the Great Depression.
And it still outperformed the Pay Off The Debt team.
It is far more likely you get a number close to the S&P 500 rolling 25-year average of 11%.
You want to take a guess how badly you'd be kicking yourself for paying off the mortgage in that scenario?
So to recap Team Invest with S&P 500 average returns:
25-Year Total:
Paid-off house + $5.4M
The lesson here is simple:
1. Do the math
2. Don’t believe everything on reddit
Final Thought
This works the opposite way as well. If you have credit card debt accruing at 20%, pay that off immediately!
