I am not sure exactly how to phrase this question but it is one that I’ve been curious about for a while. Tons of people in finance always are okay with debt at low interest rates but are quick to pay off high interest debt. Why don’t people take the amount of capital into consideration? Example: I have $10k of debt at 12% interest but have 100k invested earning 8%. Despite me earning a lower APY on my investment in comparison to the APR on the debt, I am still earning more money annually. That 100k will be $8k earned after the year at 8% but the debt will only lose me $1200. So why would one be quick to pay off high interest debt if it’s a lower principal compared to having a higher principal at a lower rate?
In: Economics
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You’re thinking about existing dollars. And kind of ignoring the obvious scale issue.
New money invested in that 8% pool will yield less net worth improvement over that high interest line.
Or think of it another way: if I gave you $10K right now, which makes more sense: earning $800, or saving $1,200.
First we can look at the simple scenario, where the 100k investment is super liquid like a high yield savings account. You can withdraw any amount at any time with little to no difficulty.
In that scenario your best play is to withdraw 10k and pay off the debt. Here we can just ignore 90k of the investment since it’s going to be earning interest anyway. We’re only making a decision on the 10k that we could withdraw or not. If we withdraw it and pay off the debt then we lose 8% on 10k but save 12% on 10k, which is a net win.
So long as your investments are similar enough to that simple case it’s best to pay off higher interest rate loans early.
That then leads to times when an investment doesn’t act like that. Perhaps you have an investment that is all-or-nothing. You can hold onto it, or sell the whole thing off. Perhaps this is something like an investment property, where you could sell the property or continue to rent it out. In this case you’d be well served to consider total investment returns, so keeping the property and servicing the debt may be smart. However, you should also consider how you’d re-invest the $90k if you did sell, which may tip the scales back in favor of selling the lump investment and paying off the debt.
Another scenario might be an investment that is hard or costly to sell early. For example, perhaps you have a bond that has a maturity in 5 years, but you can sell it on the market to get quick cash by taking a bit of a haircut on its value. Here it may make sense to hold the investment to maturity to avoid that loss.
Instead of $100K earning 8%, think of it as 10 packets of $10K earning 8% interest. In that case it is obvious that it makes sense to pay off the $10K of debt.
You may be forgetting the fact that multiplication is distributive.
> So why would one be quick to pay off high interest debt if it’s a lower principal compared to having a higher principal at a lower rate?
Because you don’t need to spend the whole $100k to pay off the $10k loan. The full $100k is not at issue, just the $10k
Think of it in two buckets… $10k + $90k
The $90k is going to earn you $7,200 regardless. So, just ignore it
On the other hand if you don’t pay off your 12% loan the additional $10k in capital will earn you $800 but you will $1200 in interest, netting a negative $400
Altogether this means you’ll earn $6800
Whereas if you pay off the 12% loan you won’t earn the $800 in interest on that $10k of capital you preserved, but you also won’t pay the $1200 interest on the loan, so overall you will net $7200
The amount of capital you have above the amount of the loan is completely separate and does not factor in at all
In your example, you’re comparing different volumes – which means you’re comparing an orange to a watermelon. You should be comparing an orange to an apple (something of similar size).
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You have $10k debt and pay $1200 a year.
You have $100k making $8k a year.
1. You should look at this as you have $90k making $7200/yr
2. And you have $10k making $800/yr.
So the question is, do you want to spend #2 to make $800 so that it can be used to pay the $1200 interest, thereby you would still owe $400?
Or would ya rather use #2 entire balance of $10k and pay off the debt?
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The simplest way to look at money is by %. There’s percent going out (which is debt) in this case it’s 12%, then there’s percent going in (which is investment/profit) in this case it’s 8%. Since the percent is higher than going in, then you should focus on removing it.
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