Financial Question - have the cash, do I pay a loan or invest it?

I'm going to use fake, round numbers here to make this easier.

General question:
If I have $15k, should I apply it to the principal of a loan that is at 5% or invest it knowing that the investment will always provide exactly a 5% return each year? This seems like straight math, but something tells me it is not.

More realistic question:
If I have $15k, should I pay off my car loan and trailer loan, assume both are around 5%, or invest the money?

What about applying it to my mortgage instead, which is around 3%? We take the standard deduction on our taxes, if that matters.

-BEP

Not a financial expert, so take this with the appropriate number of grains of salt....

First off, you'll NEVER know the return on an investment ahead of time. Paying down the loan is therefore the more conservative "investment" - you're guaranteed to make 5% on it.

Secondly, do you have several months living expenses tucked away in addition to the $15k? If not, the more conservative option would be to put that $15k in a liquid, low-interest bearing account as a rainy-day fund, instead of looking for investment growth or debt paydown.

IMO, paying down the mortgage is what you do after you've already got ALL of the following squared away:

(a) rainy day fund that will pay all your living expenses for 12 full months,
(b) retirement savings on track to hit your retirement goals
(c) college savings appropriately on track (if applicable for kids/family)
(d) all other loans (which are likely higher interest) paid off

As a final addendum, my advice for anyone is to do a lot of homework before you even think of investing. It's real easy for uninformed choices to turn into poor choices.

Jonman wrote:

As a final addendum, my advice for anyone is to do a lot of homework before you even think of investing. It's real easy for uninformed choices to turn into poor choices.

Just to echo this, I worked out in the Dulles tech corridor in Northern VA during the big NASDAQ boom of the late 90s and there were a bunch of places like MCI, AOL, and other hot tech companies, and the market was INSANE in those days. I spent some horrible months at Nextel's shiny new HQ (a godawful job, incidentally), and loads of my coworkers did nothing but day trade penny stocks, and did pretty well (and it's all they did, all day). I said, well, they can do it, so I got me an online brokerage account, put $2,000 into it, and bought a few stocks after doing a bit of research.

A few weeks later, the NASDAQ crashed, hard. Like, just a few weeks. In a year, my $2k was worth a couple hundred bucks, and it went down from there. All those shiny new buildings along the tech corridor went vacant, a bunch of people I knew lost everything, and I got a financial advisor to help with retirement and college planning. I was a freaking idiot who figured, sure, I can do it, and I just don't have the attention span or experience to invest.

Going back to the original post, we're in a time of great financial uncertainty, and heading towards very likely a rough year. I'd make my first priority making sure I had a significant nest egg to cover unexpected expenses or loss of employment, and my second would be paying off a loan. Now's a time to be highly conservative and cover your butt.

I appreciate the advice, guys. All good points.

I don't think I phrased my questions well. I was really trying to understand the math.

There are a million ancillary factors that could come into play in a real-life scenario, but in a sterile scenario of paying X dollars on a loan that is a 5% APR loan vs. making exactly 5% a year investing it, is there any difference?

What about if that 5% loan has the interest front-loaded like a mortgage; would that make a difference?

-BEP

If you plot a cumulative loan interest curve, it's going to start off steep, and then level off. If you plot an investment curve, it's going to start off flat, and then get steeper as compound interest takes effect. At some point, the investment curve will overtake the loan curve. If this happens before the time period of interest runs out, then investing is the right answer. If not, then paying off the loan is the right answer. But the interest rate affects where this crossing happen, and the loan period also affects this by shifting the loan curve. So even in the "sterile" scenario, there's no clear answer without more information.

In a real-world scenario, the loan has already been in progress for some time, so the starting point for the investment curve won't be in the same place, so that will add another shift.

Another factor to consider is the rate of inflation. If you're holding on to investment accounts that are making little or no interest and the inflation rate is high, you're effectively losing money. Loans, on the other hand, may effectively let you defer some of your debt to a time when it's a smaller fraction of your income.

Are your itemized deductions just not worth it? Or did you just get a mortgage? 3% sounds like a recent rate. You should look into seeing what you can get from itemized if you haven't.

Thank you for the explanation, Deftly. Completely makes sense. And thanks again to Jonman and MMD (from one of the best comics ever) for the level-headed advice.

Our mortgage APR is 3.125%. We're exactly 1 year into it, and it's a 15 year loan.

I'm not sure why the itemized deduction each year doesn't make more sense than the standard deduction. Housing is cheap here so my mortgage interest isn't as high as most people's would be. My property taxes aren't too awfully bad, although they did go up with the new house. We don't have kids. We don't have a lot of medical bills, and that has gotten even lower with my new job because my healthcare is free there. One place we fail is tracking what we spend on teaching supplies for my wife, but that is probably less than $1,000 a year. When I go through the tax software each year, it's generally just a bunch of No, No, No, No, No, No...

-BEP

bepnewt wrote:

I'm not sure why the itemized deduction each year doesn't make more sense than the standard deduction.

Short answer - because the Trump administration almost doubled the standard deduction for tax year 2018 in the same tax bill that handed billions out to the rich.

Prior to that, itemizing due to mortgage interest for a normal sized home made sense.

First and foremost, how’s your emergency fund? You should have at least 3-6 months of expenses saved up before you even think about paying off debt or investing. After that I would pay down most of the loan and maybe invest a couple thousand.

Not a financial expert btw but I got burned in the last recession when we ran through our savings after a baby and then I got promptly laid off.

Here is what the conventional wisdom is when you have extra cash:

If you don't have an emergency fund, build that first (at least 2-3 months expenses)
Next pay off high interest debt like credit cards
Next invest in tax free investments (401k, 529, etc)
Next max out your Roth IRA if you are younger
Next pay off medium interest debt (your 5% loan falls into this category)
Next max out your Roth IRA if you are older
Next invest in general index funds
Never pay off low interest debt unless you just want to be debt free (0-3% stuff)

In your case, if you already have decent savings I would look at maxing out your IRA or 529, unless you are over 50 or don't need to worry about college expenses. The tax savings plus compound interest over time will generate more than your 5% loan is costing you.

However 5% interest is on the border of the "retirement investment vs debt payoff" question, so if emotionally and mentally you would feel better at having the loan paid off, go ahead and do it. It is not a huge loss financially and peace of mind could be worth it.

For general investments, even if you could guarantee a 5% investment return (you can't) those returns would still owe taxes and also cost transaction/management fees, so you would end up closer to the 3.5% range.

(I am avoiding the whole Roth IRA vs Traditional IRA conversation since that is a whole other thing that highly depends on your personal circumstances. If you do decide to invest in IRA it is worth further exploration.)

Don't forget "5% return" on your investment, is that pre-or post-tax?

Those dirty socialist liberals keep wanting to tax your capital gains (JOKE ALERT... JOKE JOKE JOKE SARCASM DON'T BANISH ME TO D&D), so the straight math only works if you are doing it all on the same tax calculation.

To answer the original question, the options of paying off the loan vs investing are equivalent in a world without taxes or inflation (and assuming constant investment returns and interest rate/loan repayments). Since we don’t live in one of those they likely aren’t.

Considerations are whether the loan repayments are deductible against taxable income. How and when the investment income is taxable. Inflation can make a big difference if it rises above low levels especially if either the loan repayments or investment return don’t move with inflation.

A rule of thumb is to pay off non-deductible debt before investing.

Another key question is your view on risk. You may value the consistency of paying down the loan vs the potential variability of the investment. Or you may be happy knowing that on average you will get a better outcome from the investment over the longer term but now we are departing from the premise of the question