Of course. Smart A$$.
No, really. It depends on a ton of different individual factors that are unique to your specific situation. Funny enough, I’ve been taking about this very question with a bunch of folks. One friend has retirement savings that need a new purpose. Another is debating between adding debt to purchase a rental property vs. pay down their home mortgage. And, we’re asking a similar question about how we could move closer to our work locations and acquire a second rental property. My point is simple: everyone faces these kind of trade off decisions routinely. I don’t think I could or should answer the question for anyone else, but I think there is a framework that folks can apply to their own situation.
At the heart of this topic is the concept of opportunity cost. (Hold on to something solid; this gets heavy quickly.) Opportunity cost is what you give up when you commit. Just got married? Congratulations; you just gave up your chance to date Claudia Schiffer (Or Justin Timberlake).
Bought a CD? For the money you invest in CDs, you’re giving up on the chance to buy Amazon stock with those dollars.
Bought Amazon Stock? Those dollars won’t be buying into the Uber IPO.
Bought Uber? Those dollars won’t be buying a rental property for you.
To get more technical:
…opportunity costs are used to measure the differences in returns between a chosen investment and one that is forgone. For example, consider a person who invests in a stock that returns a paltry 2% over the year. By placing his money in the stock, the investor gives up the opportunity to invest in another investment, such as a risk-free government bond yielding 6%. In this situation, the opportunity cost is 4%, or 6% – 2%.
Read more: Opportunity Cost Definition | Investopedia http://www.investopedia.com/terms/o/opportunitycost.asp#ixzz4HBW1h1hG
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Sounds easy doesn’t it? Let’s take a more personally relevant example to understand some of the nuances of this kind of decision. Say that I have an extra $1000 sitting around. As cash, it might as well be under Aunt Bertha’s mattress. What should I do with it? I see a couple of options.
- Pay down bad debt: one of our car loans
- Pay off our other car loan and start a “debt snowball“
- Save/invest it for our next rental property
This one is pretty straightforward. Say our loan balance is about $5000. The interest rate is 2.25%. We’re a few months into this one due to the untimely demise of my beloved Scion xB. Of course, our first car loan doesn’t change at all. So, by paying down Loan #2, we payoff the loan 14 months earlier, and avoid about $80 in interest over the life of the two loans. Our total interest paid for Option 1 would be $743.02.
After almost 4 years, we have about $1000 left on our first car loan. Let’s say our payments are $100/mo. So, by paying the loan off now, we save a whopping $11 in remaining interest and free up $100/ mo to apply to the other car loan. This is the start of the “debt snowball” popularized by folks like Dave Ramsey. In short, it’s an emotionally satisfying way to pay down your debt. Although, it’s not financially optimal(this is an awesome tool; check it out for your specific situation). After paying off the first and applying the payments towards the second, we find the total interest paid for Option 2 is $689.60. Sounds a bit better.
This is the most complex of the three. We carry the existing two loans without avoiding any interest. The rates are pretty low, so maybe it’s OK. Now, a low cost bond fund has historically returned 3% (Vanguard’s has been a bit better with all the craziness going on over the past few years). We’re looking to invest the money for three years. If we assume past performance is indicative of future (possibly a BAD assumption), we’re looking at a potentially life changing $91.32 in distributions. Our net interest paid for Option 3 would be $651.70.
So, how do these three options compare? Someone play the “wah, wah” trumpets. OK, I’m hoping that while our numbers aren’t terribly exciting, this concept is.
Trade-off between paying down one loan, debt snowballing another, and investing funds instead.
It looks like Option 3 provides us with the best overall benefit. What if we were willing to wait a few more years? What if we consolidated our car loans into a lower cost HELOC? What if …? And, that’s why I said, “it depends” way up front. Your specific situation will vary. Maybe you have higher rates or larger balances. Maybe you’re questioning weather or not you can afford to make extra payments each month.
The point is, you can use math to help make the best decisions possible with your limited dollars. Those dollars can be the seeds of your future.