Does paying off debt with low interest rate even make sense?

[miriamc]

Given that S&P 500 Index has been increasing at 6.3% on average every year, does it make sense to pay off debt with interest rate lower than that?

If you currently have 50k in index funds and have 10k in debt with 4% interest rate,

50 * 1.06[sup]n[/sup] - 10 * 1.04[sup]n[/sup] will significantly be bigger than (50-10) * 1.06[sup]n[/sup] and will always be bigger as long as the rate is under 6.3.

So to me, paying off anything under 6.3% interest rate doesn’t make sense in the long run. Am I thinking correctly?

TL;DR : If I can, should I get all the loans I can with interest rate beneath 6% and invest it all in index funds?

 

[tomhw]

@miriamc Mathematically no but sometimes there isn’t a price on emotional happiness from being debt free.

 

[reinachloe]

@tomhw I try to pay down as much as I can afford to because I want to be debt free.

 

[vanjonti]

@tomhw Your emotional happiness of being better off when you're old outweighs the happiness of being debt free now. If you have the money to pay off the loan then it's meaningless to actually do so, if that money is generating more money.

 

[tomhw]

@vanjonti I can tell that you don’t work in finance. Sure that makes sense to you but try explaining that to someone who doesn’t care if the markets have a 100% return. They. Want. No. Debt.

 

[vanjonti]

@tomhw I believe you. But the question was whether it makes sense. Valuing being debt free now and ending up poorer than you could be later doesn't make sense. Of course people often don't make sense.

 

[lisneige]

@miriamc You also need to account for taxes. Interest rate of 4% tends to be where it starts to become a grey area. Also that 6.3% is over the long term, SPY is a bit above where it was 2 years ago. In the shorter term the market can and will go down

 

[seekinggod888]

@miriamc Me and my hubby have this debate all the time. Home mortgage $112,000. Payment with escrow is $725.00. Interest rate 2.75%.

I think we are way better off investing than paying this down. Idk...we really go back and forth on the issue.

 

[gloriouslight]

@seekinggod888 A mortgage at that rate in this economy is precious. It might be a more valuable asset than the house.

 

[seekinggod888]

@gloriouslight You wouldn't believe how many calls I get trying to talk me into taking money out or refinancing to move us off this rate. NO WAY IN HECK are we going to do that.

 

[yhyde]

@gloriouslight Yeah I bought when rates were low and my biggest regret in life to this point is not buying as much as I could afford. 2 kids later and now it’s hard to make myself move on to a bigger home. Hoping 2-3 years is enough time for at least a little better rate

 

[caitlynlovesjesus]

@gloriouslight You definitely have a great loan, but a loan none the less. So what I would do in order is this:
' build a huge emergency fund of up to 12 month expenses
'Pay off all debt except home
'Run a retirement planner to see how much you should be investing to have an awesome retirement
'Is it important to invest for kids, if any, college expenses
' Now aggressively pay off mortgage.
'n

 

[larryedb]

@seekinggod888 Yeah it really doesn't make sense to pay that off any faster than you need to. A HYSA or CD can beat that if you don't want the risk of equities, even after considering taxes.

Putting any more money down just locks it up in an illiquid "asset" (because primary residence isn't an asset for FI/retirement purposes) at a below-market rate.

 

[promise53]

@seekinggod888 If you can get a better rate on a HYSA or other risk-free instrument, then it's no contest. You get free money for the life of your mortgage. If you can't, it's still probably a good deal to invest.

 

[pastorlou]

@miriamc Mathematically: no.
Nuanced answer: it highly depends on your age and cycle of life. If you’re 30 years from retirement, no. If you’re 10 years from retirement, maybe. Generally speaking the closer to retirement you are the more you benefit from paying off debt because while the dollars invested will compound more and offer a better return paying off the debt gives yourself a tax free “raise” which can be equal to a 20+% rate of return.

Say your mortgage is at 3% so half the anticipated long term average of the S&P 500 and your monthly payment is 2k. If you’re 35, maximize investing. If you’re 55 don’t stop investing and don’t decrease contributions but over paying your mortgage will save you 24,000 per year in retirement and will reduce your withdrawals. If you succeed in paying it down before you retire then you now have an additional 24k annually and your take home hasn’t changed.

 

[galapagoschange31]

@miriamc Past performance does not guarantee future. IMO there is no greater feeling than being debt free. You could lose your job and only worry would be food and water

 

[pmcr63]

@galapagoschange31 Having to worry about food and water with $0 in the bank seems worse than also having to worry about mortgage payment but having $100k+ in the bank.

 

[galapagoschange31]

@pmcr63 Once you have no debt saving enough for an emergency fun should take 1-2 months max

 

[pmcr63]

@galapagoschange31 But why drain your emergency fund in the first place? Seems like unnecessary risk.

 

[missy90]

@miriamc

1. The long-term nominal return is actually ~10% annual, not 6.3%.
2. In the long run, you're still right - it makes much more sense mathematically to be 100% stock than any other asset allocation. But life is not a mathematical model, and in actual practice, it is not feasible because...
3. You're ignoring volatility and risk. There are years where the S&P will go down 50%, such as in 2008, and you can expect a bear market (-20% or more) once per decade.
4. Those bear markets are highly correlated with poor macroeconomic environments and job loss. So in a worst case scenario, you're most likely to lose your job & income right when the market is tanking, such that you'd be selling at the bottom to pay your bills.
5. The relevant question: can you stay liquid in a market downturn longer than it takes for things to turn around?