How do I use debt as money

Should you repay your debt right away or invest your money?

Optimal financing | Saving sensibly

Would you sacrifice millions of people to save one person?

This scenario is often used in this or a similar form in series and films. Some villain gives our hero or heroine a choice: will you save the love of your life or millions of people? You only have time for one of the two scenarios and you only have 5 seconds to make your choice.

From a purely rational point of view, our hero should always save millions of people. But the decision is never purely rational. There is always the emotional and psychological aspect, of course. It's about THE love of life! That's exactly why our villain does it, and that's why Hollywood scriptwriters love to use this scenario.

None of us make the majority of our life decisions on a purely rational basis. Emotions always play a smaller or larger role.

The decision of whether to pay off your debt first or invest your money is another such decision

Of course, it's not a matter of life and death. Most importantly, you can take your time with the decision and think it through. You don't have to decide in a second like our Hollywood hero from above.

There are several ways to think about the subject - this article is designed to help you make decisions and, most importantly, to make sure you avoid making mistakes.

Approach: The number-oriented view

How much interest do you have to pay? How much could you make from an investment?

From a purely rational point of view, the subject seems simple. We just have to look at how much interest we currently have to pay back and how much we can get if we save / invest our money.

One thing we should clarify in advance: If you have one Consumer credit or coated account frame where you pay more than 4% interest per year (and that would be really cheap for some bank accounts and consumer loans), then you can save yourself the bill.

Do everything in your power to repay your debts as soon as possible. You should generally avoid consumer loans and overdrafts, but if for any reason you have this type of debt, repay it as soon as possible. Don't waste any thought on investments. Your first task is to eliminate this debt.

Things look different if you have taken out a fixed-rate loan for your property purchase

To make the calculation as simple and clear as possible, let's assume you have € 100,000 in credit. We assume a fixed interest rate of 1% p.a. for 20 years (Annotation: You won't get that anywhere, except for certain housing subsidies, but for our example we'll pretend that is the case).

That would mean that you would have paid back the € 100,000 loan in 20 years at a rate of around € 460 per month. In the 20 years, interest accrues just over € 10,000.

What should you do now if you can repay more than € 460 per month?

Let's say you could repay an additional $ 200 per month on the loan. What is the best practice? Simply repay the € 2,400 (12 x € 200) every year and thus finish repaying the loan earlier and pay less interest, or would you prefer to invest the € 200 long-term?

If you just look at the numbers, the answer is very simple

After you have a fixed-rate loan for the entire 20 years and which is 1% in our example, there is no planning uncertainty with the loan. In this case, we don't care about fluctuations in interest rates, we have a fixed interest rate. We know exactly how much has to be paid in the 20 years.

Basically, the only question that arises now is: if we invest our money for 20 years, can we achieve a return of more than 1% per year? (annotation: It has to be a little more, since we also have costs and taxes for the system)

The answer to that is a resounding YES (why you can read about why and how you should invest your money ...).

You should definitely invest your € 200 long-term - purely based on numbers. If we assume a return of 4.5%, then we will accumulate almost € 30,000 in “profit” over 20 years.

Wouldn't it make sense if you only repay the interest for 20 years and only repay the entire loan after 20 years?

Yes, if that would work, then this is an even better variant in our example (always assuming that we achieve a sufficient return - that is practically safe over 20 years and at 1% fixed interest rate). However, currently (as of 2019) practically no bank grants you bullet loans (= loans that are only repaid at the end of the term). So we can discard the idea 😉

In a purely number-based view, the topic of inflation also plays a role

While inflation is the saver's enemy, it is the debtor's friend. The € 460 you pay back in the example above is an absolute and fixed amount. At the moment, € 460 have a certain purchasing power (for example, you can buy around half of a new iPhone 😉). 5, 10 or 15 years later, the purchasing power of your € 460 is less and less. So you pay back your loan with increasingly “cheaper” money.

But stop for a moment: Is the decision really only to be viewed rationally?

Don't psychological factors also play a decisive role? Yes of course. As mentioned at the beginning, emotions and psychological factors also play a not to be despised role in almost all decisions (especially "money decisions") ...

Approach: the psychological consideration

It is wonderful to do all kinds of arithmetic games. In such clear situations as in the example above (very low fixed interest rate for a very long time) it is also easy to rely on the numbers. But you don't always find such clear situations in reality.

If you don't have a fixed interest rate at all, but a variable interest rate that can change, then the calculation becomes more difficult. Above all, however, the exact prediction of the future becomes practically impossible (as is so often the case 😉). We can set up the most beautiful mathematical models, calculate everything and come to the conclusion:

  • "Yes, you should use the amount X to repay your debts" or
  • “No, you shouldn't pay back debts, but invest the amount X”.

At the end of the day, of course, it will be a personal choice

This decision is influenced by psychological factors and emotions. If you are sleeping badly because your loan size worries you, then it probably makes sense to repay more debt - regardless of whether investing would be a bit more beneficial (or you shouldn't have taken out the loan in the first place, but that's another topic).

If you are completely free of pain and emotionless when it comes to credit, then you should rely even more on the numbers.

If you are unsure, you can play through the following scenario

Just imagine the following:

  • The numbers speak for the investment and NOT to repay the loan in addition.

Are you someone who keeps an eye on the status of your investment every day? What do you do if after 3-4 years there is 20% less in your savings pot, i.e. what you have paid in? Are you close to a nervous breakdown?

Then just leave it and pay off the loan.

Or you have to learn to deal with the fluctuations and to accept them. To do this, however, you must have dealt with it beforehand (you are currently doing that 😉). "On the fly learning" is usually extremely difficult when it comes to fluctuations in investments. If you see the -20% in absolute numbers, then you must have made yourself aware beforehand that something like this can happen and is normal. Otherwise you can no longer make rational decisions.

What else could speak against the investment, although mathematically everything speaks in favor of it?

If you tend to spend your money rather than leave it somewhere long-term, then repaying the loan may be preferable after all. Because there the money is actually “gone” (in a positive sense). It's not lying around at hand when the urge to take a second vacation a year or to spend a few thousand more on buying a new car or interior is great.

The less disciplined you are on such issues, the sooner you should pay off the loan instead of investing.

One thing must still be clear:

Psychological factors do not excuse really stupid and above all wrong decisions

This applies in general, but in the special case of loan repayment in both directions. If you really found yourself in the example discussed above (1% fixed interest rate over 20 years), then it would actually be stupid not to invest your extra amount. No matter what fears you have about investing (check out our article Are Stocks Really That Risky? A Bullshit-Free Analysis).

However, if you have a not so good variable interest rate over 30 years, the loan is already tight and you feel really uncomfortable with the debt ... then it would probably be stupid if you NOT repay your loan early. Even if you think that your investment will generate great returns.

No matter what situation you are in. I have a rule of thumb for you ...

You should always save something in the long term

I have already written about the fact that when saving for your own property, it does NOT make sense to save everything just for the property. The same goes for repaying your loan. If the credit is such that you can't save anything extra, then the credit is probably not optimal. Or to put it another way: you actually can't afford the loan. Investing some of your money long term is probably the most important decision you can make.

Your goal must be to make the "right" choice & decision in as many financial decisions as possible and as often as possible

In the case of tight results, this decision does not always have to be mathematically correct. It just has to fit you emotionally and psychologically. As long as you don't use baseless fears as an excuse for making stupid decisions, as mentioned earlier. The film heroes usually manage to achieve both - they save their loved ones AND the millions of people. In contrast to the Hollywood blockbuster, our life is not a movie. The more often you make financially wrong decisions, the worse off you will be in the end.

The more often you take the right action on the essential (financial) issues in life, the better off you will be in the end

So that YOU become a hero or heroine in all financial topics ...

Author: Florian Märzendorfer

Indian food fan, financial planner & co-founder of FiP.S.

Hates beach vacations & hates comma rules.