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
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.
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