Should You Invest, Save or Pay Off Loans?

A friend and I had an interesting discussion some time back. He has a lot of student loan debt and plenty of savings, enough to pay at least half of the debt off. He lives rent free right now, and he and his wife are fortunate to make a very good six figure income. Their number one priority this year is saving up for a down payment for a home.

I advised him to focus on paying off the student loan first. My suggestion was for them to throw most of their savings towards their debt and then live on one income. The second income could then go towards debt elimination, followed by the funding of their down payment.

He, on the other hand, was not comfortable with that. He gets a sense of security from having a large amount of cash reserves. In addition, given the excessive amount of interest his student loans accumulate each month, he sees more value in acquiring a place of residence. As it stands, the monthly student loan payments he makes barely go towards the principal. He feels that at least he’ll be building equity by purchasing a house. For him, the return on investment on a house is greater than that of paying off the loans.

Which one of us is right?

You may all have differing opinions too. The truth is that there may not be a right answer. Each person can approach this situation from various angles and make a strong case for themselves. This is where the personal in personal finance comes in. A situation like this isn’t just about the math. Your feelings, your emotions, your psychology, your goals and your values also come into play.

Why I think the debt should go first

When I imagine myself in his situation, I feel compelled to get rid of the debt. I’m a frugalist by nature, and like my friend, I’m very much a saver. I too get some comfort from having money stacked away for unexpected life events. Having been through layoffs, long periods of unemployment and family tragedy, I cannot overstate the importance of having cash sitting in a savings account, even if it’s only earning 1%.

However, owing people money scares the hell out of me. The only debt I’ve ever had is student loan debt, what some people like to call “good” debt. The truth is it’s not good for me. It doesn’t give me a good feeling. Having debt makes me feel like I’m not in control and that somebody else has power over me. This would be the first reason why I’d get rid of the debt. I’d prefer to know that I don’t have shackles around my feet. Knowing that I’ve not enslaved to anyone and that I’m free to do whatever I want with the money I earn is liberating for me.

The second reason I have for getting rid of the debt is that in the event of job loss, you want to ensure that your savings are only going towards your basic needs. I understand that you’re able to defer student loan payments but they would still be accumulating interest. Let’s imagine this was credit card debt. I don’t think credit card companies are as “nice.” They don’t really care about your income situation. Plus, even if they do give you a little “grace,” it’s not out of the kindness of their hearts. Credit card companies love it when you have you don’t pay them in full. You give them the opportunity to charge their high interest rates to the balance, which means that ultimately they’ll get a lot more money out of you.

My third reason for wanting the debt paid off quickly is because I believe you get a guaranteed return on investment. Let’s take my student loans for example, two of which are at 6.85%. The way I see, getting rid of them gives me a 6.85% rate of return as opposed to the 1% rate I’d get from a savings account. In addition, historically, the stock market has averaged anywhere from 6-8%. While the returns of the loans and the stock market appear to be similar, market returns are not guaranteed.

Finally, while I’ve never owned a home of my own, by all accounts, owning one isn’t always all it’s cracked up to be. Besides the hefty mortgage, home ownership comes with maintenance costs and repairs that you and you alone are responsible for. Those additional costs have to fit within your budget, or else you’ll find yourself adding more debt to the equation. Getting rid of expenses such as student loans and credit cards will increase the gap between your income and expenses, thereby creating more room in your budget, and thus enabling you to take care of home improvements with cash.

The above reasons are based on my values and my goal of being debt free, as well as my psychology of having financial control and not being indebted to anyone. I would be most comfortable with temporarily reducing the amount of savings to tackle the debt, and then building it up again and setting some funds aside for the house.  I believe that debt limits your options.  You should get rid of it as quickly as you can so that you can strictly focus on building wealth.  When you don’t have debt tying you down, you can invest from a place of financial strength.  Without other people’s hands on your money, you’re able to keep all of it and you can easily jump on great opportunities that arise.

However, you, like my friend, may not agree with me. You may not feel the urgency of paying off debt, and you may prefer to buy a home first, or perhaps invest in the stock market. At the end of the day, you have to do what works for you. We all have different resources, values, goals, and temperaments. What works for me may not work for you and what scares me may not scare you. When it comes to personal finance, one size does not fit all.

What would you do if you were in my friend’s situation?

 

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