If I have the money, should I pay back my loan?

Mr. Lyn and I asked ourselves this question recently. We realized that to answer it you have to take into account two things: numbers and emotions. It is also important the weight that each factor has on us. Let’s analyze them step by step.

The numbers

The key concept here is the opportunity cost. The loan has costs associated to it. Can I invest my money somewhere that gives me higher returns than the costs of my loan? If so, your money can be in a better place than paying the loan in advance. Let´s see it with an example.

Sonia has € 500 monthly after basic expenses (house, utilities, food, loans, etc.). She also has a 3-year loan in which she pays € 400 per month with a 3% interest.

What should Sonia do with the €500 she has remaining every month? She can save it, spend it or invest it.

Should Sonia accumulate those € 500 every month until she has enough to pay off the loan? Or should she keep paying the loan in comfortable installments and use the money for something else?

Due to the crisis, Sonia´s interest are quite low (only 3%) so there are assets that will yield more than 3% returns. For example, Sonia can invest it in an Index Fund such as the Vanguard S & P 500, which has an annualized 10-year return of 11%.

Details here:

http://www.morningstar.es/es/funds/snapshot/snapshot.aspx?id=F0GBR04G0F&tab=1

So, if Sonia is willing to invest in as asset like an Index Fund it would be better to invest the 500€ per month than accumulate them and pay back the loan. She will get higher returns by investing.

However, if she does not consider investing the money in a high-returns vehicle, the best thing to do is save up and pay back the loan.

The loans have a cost. If you can avoid paying fees, life insurance, etc., much better. Keeping significant amount of cash in a checking account or in a deposit is not going to give you better returns that the cost of your loan. So if you are not willing to invest in other types of assets I´d definitely recommend to pay back the loan instead of keeping the money idle or spending it on a vacation or a car.

The emotions

The numbers can send you in a clear direction, but you have to consider what kind of risk you are willing to take and how does having a loan weights on you personally.

For example, I am open to risk in my investment strategy. I have my savings invested in index funds, and I am aware that the value can change and I can see my investments shrink at a certain point in time. I believe in the long-term gains and I think I have the mental strength to navigate the crises, keep investing through them and wait for the market to recover.

On the other hand, I do not like having loans. I have a stable job and I know that I can pay my loan comfortably in small monthly payments (I have quite low interest) and deploy as much cash as possible in index funds where I will obtain more long-term returns. But mentally it doesn´t work for me. I am not relaxed knowing I have that financial burden so I saved as much as possible when I started to work, accumulated the cash I needed to pay back my loan and canceled it. Now that I know I don´t owe any money, I invest every month my savings in my portfolio.

On the other hand, Mr. Lyn is true to numbers. He also has a low interest loan (2% + Euribor) and he is not planning to cancel it yet. Mr. Lyn clearly sees that his money is better deployed elsewhere. He chooses to do small contributions to the loan every month and keep investing the rest of his savings. As I mentioned, I do not like debt so I am trying to convince him to change strategy and send more money towards the loan but I haven´t been successful so far.

what about you? Are you the one who pays back asap or you prefer to pay slowly and have a better cash flow?

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