I recently refinanced my loan from 4.25% to 2.875% and lowered my loan time from 29 years to 15 years. While my monthly payment went up a bit, I am saving thousands of dollars in interest over the life of the loan. With such a low interest rate, it makes me wonder if I should try to pay off the loan early or invest my extra funds?
Cost of Debt
Over the lifetime of the loan, assuming no more early payments, I would owe $23,225 in interest. That is a lot of money.
Just think of what you can do with $23,225? Buy a car. Take a trip around the world. Invest and save for your future. It is so much money that there are even articles about what to do with $25,000.
On the other hand, 2.875% is a pretty low rate. At that rate, it may be possible to earn more, offsetting the cost, by investing in the stock market.
If you can earn 3% on what would have been an extra payment, you come out ahead. If you can beat that, you are making even more.
The S&P 500 has a compound annual growth rate of 9.94% since 1970, so it would seem that it could be easy to buy a low fee index fund and make more than 2.875%.
If it were that easy, everyone would be making on average 10% each year with their investments. However, there are investment risks.
Over the period that the S&P 500 had a CAGR of nearly 10%, 9 years had a decline. With the volatility we’ve seen over the last several years, it is impossible to say what is going to happen next. (If you do know, please tell me.)
Reasons to Pay It Off
Seeing as we never know what the market is going to do next, we don’t know if we can certainly beat 2.875%. In fact, we could end up losing money if we invest over the same time horizon.
However, we do know that no matter what happens with my investments, I will owe the bank $23,225 in interest. Because I’m not sure if I can beat $23,225 by investing, paying off the loan makes more sense to me.
In addition, until the loan is paid off, I will always owe the bank the remaining principle on my loan. Right now, that is about $97,000. I would sleep much better at night owning my condo outright and not having to worry about paying off any loans.
There is Always a However
However, I am currently looking at saving up for a second condo. If I do that, I can rent out the current one for a profit and live in the second one. My best estimate is that I could make about $500 per month, if not more, in monthly profit by renting it out.
So here’s my plan: Split the difference.
I plan to pay extra into the loan each month and save extra each month. If I can pay $200 extra per month into the loan, I will save about $6,000 in interest and cut nearly 4 years off the loan. If I figure out how to put more, even better.
That will allow me to save to invest in the future while saving myself money on my current loan. I call that a win-win.
Image by JasonParis / flickr
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