Pay off loan or invest?
March 23, 2020 6:17 AM   Subscribe

Should I pay off, significantly pay down a loan, or invest? I have a lot of experience with debt, but no experience with investments.

I'm 2 years into paying a $40k, 5 year, 7.5% loan. I pay ~$800/month. As of today, my payoff amount is $28k. I have $30k in savings, $35k in exercised stock options, and ~$30k net unexercised. I also just received an insurance settlement that's $10k net. After all of my expenses, I have an average of $1k/month surplus. Aside from this loan, my only other debt is $5k in low interest student loans. No car, mortgage, etc.

On one hand, it would be great to just pay the loan, and eliminate the $800/month payment. On the other hand, as crappy as it feels, it seems like right now would be an ideal time to invest in something, while the market is being problematic. I'm thinking about this more and more because, while I have a solid job, and my company is in a good, even great position during all of the craziness going on, I'm in my late 40s, and have barely any retirement savings ($14k in a 401k). So I want to optimize things as best as possible.

It should be noted that I'm a US expat living in Europe.

So what's the best option? Pay off the loan and save the $3500 in interest? Make a large payment to reduce the interest? Find something to invest in?

Thanks for your help.
posted by Bucket o' Heads to Work & Money (13 answers total) 4 users marked this as a favorite
Will you make more on an investment than you are paying in interest on the loan? That’s the relevant math.
posted by snowmentality at 6:28 AM on March 23 [5 favorites]

Will you make more on an investment than you are paying in interest on the loan? That’s the relevant math.

Very few investments guarantee 7.5% APR return. You need guarantees if you are not phenomenally cash rich. It does not sound like you are in that category.

i) Are there early-payment penalties for the loan?
ii) do you have enough cash on hand for a few months of living?

If the answer to i is no and ii is yes (and it sounds like it), then pay the loan down.
posted by lalochezia at 6:33 AM on March 23 [13 favorites]

Pay off the loan. The market is ridiculously uncertain right now. If you lose the money you invest, then you’ll still be on the hook for the loan while having no savings. You can begin investing the money you would otherwise put toward the loan payments.
posted by Autumnheart at 6:39 AM on March 23 [9 favorites]

In your shoes, I would pay off the loan. Possibly you might make more money in the market (eventually, after more downs and then hopefully some ups), but a guaranteed 7.5% is nothing to sneeze at.

But I'd only do so if that left enough in your savings to feel like you had a workable buffer.
posted by Dip Flash at 6:58 AM on March 23

Pay the loan. That's a lot of money you're on the hook for if things go sideways-- and the odds of things going sideways are very high right now. It's also a great time to make small, incremental investments.
posted by wotsac at 6:59 AM on March 23 [1 favorite]

First up, I applaud you for having your financial house in order. Nice work. Your $1000/month surplus (or profit, as I prefer to call it) is fantastic.

I've been writing about personal finance for fifteen years now. This question comes up a lot. The "math" answer is to route your money to whichever option will likely provide the best return. But the math answer isn't always the best answer.

For most people, the best option -- regardless potential returns -- is to pay off the debt. (And, honestly, in most cases paying off the debt is the math answer too.) In your case, I'd recommend getting rid of the debt, especially giving the current world turbulence. Doing so removes a big financial obligation, which increases your "profit" to $1800 per month. This buffer between your earning and spending gives you a great deal of flexibility. It improves your financial resilience, so that you can cope with unexpected shocks and crises. Like a global pandemic.

You say you don't know much about investing. By repaying debt first, this buys you time to self-educate on the subject. Pick up a copy of The Simple Path to Wealth by J.L. Collins. Read it over the next month or so. It'll prep you for investing once your debt is gone.
posted by jdroth at 7:01 AM on March 23 [8 favorites]

Also the return on paying off the loan is non taxable
posted by canoehead at 7:12 AM on March 23 [1 favorite]

Ignoring the COVID-19 situation for the moment... pay off the loan. 7.5% is a good return. And you'll feel much better with this burden lifted from you.

Factoring in COVID-19, I'd hold off until things return to normal before paying off the loan. Keep paying the $800/month for a few months. In an emergency you want cash in the bank for if things get worse. I'd put the cash in a safe money market or bank deposit fund. It'll earn next to nothing, but it should be safe.

I absolutely wouldn't counsel investing that loan payoff money in stocks. Not at any time; beating that 7.5% guaranteed return of paying off your loan is difficult. Put it another way, would you borrow money from a bank at 7.5% to gamble it on the stock market?

And definitely not now in the time of uncertainty with COVID-19. It sounds like your intuition is you want to buy now, buying low. That's not a bad idea but the specific effort to try to time this perfectly is what we call "catching falling knives" and it is very dangerous. Investing in stocks now makes sense if you can keep the money there long term (10+ years) but trying to flip a quick profit is super, super risky.
posted by Nelson at 7:39 AM on March 23 [3 favorites]

On one hand, it would be great to just pay the loan, and eliminate the $800/month payment. On the other hand, as crappy as it feels, it seems like right now would be an ideal time to invest in something, while the market is being problematic.

Correct on both counts. Except that now is not special in being an ideal time to invest in something. It's always a good time to invest in something. Only question, as ever, is in what.

In your position, I'd be investing in your loan before even thinking about anything else.

What a loan is, is a time machine that lets a lump sum get traded off against an ongoing payment stream. Operating the time machine involves a service fee called "interest" being tagged onto the delayed side of the trade.

All a savings account is, is a loan with a very low service fee. You're making a very cheap loan to the bank, turning a payment stream you have no immediate need for into a lump sum they can use for whatever they want right now - a lump sum they guarantee to make available to you at some future time, with varying degrees of notice.

So if you've got a personal loan that you're paying off at 7.5%, and a savings account that the bank is paying you 0.5% for, and the lump sums involved are roughly the same size like your $28k loan and your $30k savings are, you're effectively operating two time machines at cross purposes and paying 7% per year on some substantial fraction of $30k for the privilege.

Doing this makes sense in a country like the US where sudden personal financial disaster is always only a broken leg or misplaced cough away, because you never know when you might need quick access to $30k. But if your loan is structured in such a way as to allow you to redraw amounts paid ahead of the agreed schedule, there's a more cost-effective way to achieve the same capability.

If your loan has a redraw facility, you can let those two time machines almost but not quite cancel each other out. Use the savings account to pay off most of the loan, but not completely because that will kill it. Then stop making loan repayments until the schedule gets close to catching up again (keep an eye on this).

The total size of the lump remains the same, but now it's your creditor who is obliged to provide most of it on request as a redraw, not your savings bank as a withdrawal. But the time-travelling portion is now much smaller, which means the 7% of it that you're paying to time-shift is much smaller as well. It only gets big again if you do redraw, and it can't ever get bigger than it is already.

Now you can redirect the $800/month stream that was formerly servicing the personal loan into your savings account instead. What that stream is now achieving, over time, is a gradual transfer of the obligation to make the paid-ahead amount available at short notice from your creditor back to your savings bank. And if that's all you do, then you end up at the personal loan's original end date with rather more in your savings account than you would otherwise have had. The 7.5% that's built into that stream is heading into one of your accounts now. That's your rate of return on that payment stream, rather than your creditor's rate of return on the lump they originally time-shifted for you.

And yeah, 7.5% is a pretty bloody healthy ROI in this day and age.

If you're going to buy stocks, you should be thinking about that as a 10 year exercise, minimum. That's the kind of time span it takes to iron out the effects of volatility. Don't ever put money into stocks that you might need to get back large amounts of quickly; that's what savings and redraws are for. Distressed selling is how to make investments work for other people instead of for you.

Best thing you can do with stocks is just accumulate them over time and enjoy the dividends as they arrive, without worrying too much about what the stock itself is trading for on any given day. Invest in a diverse range of companies whose business model you understand, that do things you think need to be done, whose board and management appear to be competent and whose financials have always been sound, and you won't go too far wrong.

Never buy at market rate. Always use limit orders and always err on the side of making the limit slightly too low. Best case: intra-day volatility gets you the stock at well below average market rate without you having had to try to be a day trader. Worst case: you keep your money and get to buy something else with it later on.

And don't rush to diversify. I did that, and it was a bit of a mistake. Instead, invest regularly but never buy the same stock twice until you hold maybe twenty different ones. Put a bit more into an index fund or two before buying anything else. Maybe even instead of buying anything else. Index funds are inherently diverse and it's quite hard to get better long term returns than they will achieve for you.

Worst thing that can be done with stocks is take a huge punt on acquiring a sudden massive load of them when the market is down 30% from where it was a month ago. You've got no idea what it's going to do tomorrow; it could drop another 30%, you just don't know.

And sure, to anybody who bought stocks over the last few years (myself included) the present state of play does look a bit like the Boxing Day sales and yes, I have been buying the odd parcel here and there for radically less than I would have paid for them a month ago. But what I'm not doing is dumping all the rest of my savings into the market right now; I'm way more risk-averse than that.

Volatility aside, about half of the outfits you invest in will probably do OK, and the other half will probably wither and die, and there is no reliable way to tell which half will be which. But compounded returns being what they are, given sufficient time the half that do OK should more than cover the cost of those that go down the gurgler.

Or you could just blow everything you own on treating the markets like a casino. You might win big doing that. People have. But most people who do it just end up funnelling everything they own upward toward the ultra-wealthy old fucks who own the algorithmic trading engines installed in closets twenty microseconds away from the exchange computers.
posted by flabdablet at 8:30 AM on March 23 [1 favorite]

And seriously, whatever happens to the price of a stock you've bought after you've bought it, don't beat yourself up for having paid too much for it or not having bought it early enough or not having waited for that market correction before diving in or any of that.

There are an awful lot of people who think they can time the market, using technical analysis tools with varying degrees of apparent sophistication. None of that shit works; it's Dunning-Kruger and confirmation bias all the way down. Index funds consistently outperform hotshot fund managers, on average.

Start paying attention to the names of the hotshot fund managers bragging about outrageously good results this year and the first thing you'll notice is that the same names almost never turn up two years in a row. And those that do, do because they're managing utterly stratospheric amounts of money, not because they're making notably spectacular ROI.
posted by flabdablet at 8:45 AM on March 23

Pay off the loan. There's no way you can guarantee a return that would exceed the 7.5%. Also, the less your monthly carry, the more you have to live on in an emergency.
posted by praemunire at 9:41 AM on March 23 [1 favorite]

I would not deplete savings to pay off a loan in full right now unless you have an emergency fund of at least a year's living expenses. There is a depression starting and widespread job loss is likely.
posted by medusa at 9:54 AM on March 23 [3 favorites]

One thing to remember is paying back the loan is like making 7.5% tax-free. If you invest the money, you need to make about 10% (if you have a 25% marginal rate) to break even.
posted by tracer at 1:16 PM on March 23 [1 favorite]

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