Asked on 21 Jun 2019
Due to some pay adjustments, I might end up with a lump sum of money, I would like to know whether it would be better to use it to pay off more loans to be loan free sooner, or use it to invest and continue paying loans on the monthly basis.
I'll pay off anything that is costing me 4% or higher. If not, I'll invest because I am confident in growing that money at a higher rate than 4%.
Being debt free is a little overrated. Some debt is ok and shouldn't be rushed to get cleared like your mortgage.
I feel that the decision made has to depend on your risk appetite.
Your debt will incur an interest, say for example 2.6%p.a. in the case of HDB loan.
If you're confident enough to generate more than 2.6%p.a. return on investment with your lump sum, then you shouldn't use it to pay off the loan, but instead invest that lump sum to generate more returns.
Conversely, if you're risk adverse and would have kept the money in the bank, you should repay the loan.
There's no need to do this 100%, you can split the lump sum partially to repay loan or invest depending on your confidence level.
Also some loans charge fees if you repay early. Do take this into account!
I actually did a spreadsheet before on a similar question. Please see https://rplg.co/slopu
The question I had was.. If I had $500k cash on hand, and I was going to buy a 500k property, should I take a loan or should I pay up for the property.
So, in scenario 1, you take a mortage of $500k @ 2.6% interest for 30 years, and then you invest $500k . Interestingly, the hurdle is just 2.8%. That is, if your investment makes 2.8% per annum, you would be marginally better off by $7.4k over 30 years.
Note that when you took a mortgage of $500k, you would have to have annual installment payments of $24,020.38.
Now, you can go to the spreadsheet link above, create a copy and play with it yourself.
There are a few other scenarios in the sheet, like for example, you pay off the property, but put the "supposed" $24,020.38 into a regular savings plan for 30 years. Feel free to try it out.
But my main point is, if you can generate 2.8% investment returns, and take a 2.6% loan, then you are better off investing. Assuming you are disciplined, and not gonna buy that round the world business class ticket.
Another 3 scenarios below
1) If you are paying 4% loan interest, and generating 4.3% Investment, you are better off taking the loan, with a $5.9k marginal profit
2) If you are paying a 1.9% loan interest (ie, bank loan), and you can generate 4.5% investment return, then you are in the pocket $477k, and you SHOULD take the mortgage, and invest the initial 500k.
3) If you are paying 2% loan interest, and you can generate 8% investment return, then you are in the pocket $2.3mil over 30 years.
[To elaborate on this scenario..
If you paid off the $500k property, and put the annual payments into the investment that generates 8%, you would have gotten $2.7mil over 30 years.
If you did not pay off the $500k property. Your total mortgage payments plus interest is $665,315 resulting in mortgage interest of $165k paid. But your $500k initial investment has become 5.031mil after 30 years of compounding at 8%.]
Too many people talk assumptions and set an invisible benchmark of "if it is XX, you should YY". The truth is your situation may vary. Personally, I rather take a mortage and invest whatever spare cash I have, because it gives me flexibility, and most secured loans (and even some unsecured loans) have ridiculously low interest rate in our era thanks to Mr Bernanke and the USA QE programs.
What is the int rate on your debt? What kind of debt is it? If you don't know what you are doing, the best is to pay of your debt.
There are a few factors to consider like Withdrawal Limit, Total Debt Servicing Ratio and etc but I assume these are not your concerns.
So, it all boils down to Time Value of Money!
Do the option where it maximise your Future Value.
So it depends on what loan you're talking about. If it's HDB loan, I rather not pay it as the effective interest rate is low, but if its a car loan, maybe I would if there's no penalty. So yea.
It's best if you know how to calculate it yourself but there are lots of TVM calculators around also.
I'd pay off the loan first before investing! Unless I am sure that my capital gains + dividend returns can beat the interest of the loan, I will pay off the loan first! Markets are pretty volatile nowadays (in my opinion at least), so I'd advise you to play safe and pay off your loans first!
I presume that your debt has a certain interest rate. Consider using half that lump sum to pay off 50% of the debt. The remaining half invest in dividend paying funds that can cover the debt interest, and you will end up with surplus instead of losing to the debt interest.
For example a fund which i provide gives a rough dividend of 8%, debt interest is at 3%+/-, you end up with a surplus of 5% WHILE servicing the debt.
It is better to be debt free. Hence I would opt to pay off one significant chunk of debt. The best is to completely pay off the debt so that I could focus all my attention on savings and investments without having to worry about forgetting to pay my debts. Just my personal opinion.
If its personal loan or unsecured loan or car loan, then its better to pay off with the lump sum.
If its mortgage loan then i think its okay to leave it as it is and use the money to invest.
In my opinion, using the lump sum to pay off loans would be much better than investing it at the moment. Moreover, after paying of the loan, you will feel much better as well.