It seems like everyone’s talking about interest rates these days.  For the past 3 years all of the financial experts predicted that an interest rate hike was imminent and consumers should curb their spending and reduce their debts quickly before the cost of borrowing went up.

After the downgrade of the U.S. government credit rating we saw huge volatility in the stock market last week.  Not only have economists changed their outlook on interest rates, pushing back their forecasted increase to the 2nd quarter of 2012, some experts have suggested that the Bank of Canada actually lowers interest rates in the short term to help guide our economy through the latest turbulence.

I think it’s clear that low interest rates are here to stay, at least for a few years.  The question becomes, should you take advantage of cheap borrowing costs to pay off debt or should you use this opportunity to invest your money?

Low Interest Rates – Pay Off Debt

When interest rates are low that means the cost of borrowing on your mortgage and line-of-credit is also low.  With variable rate mortgages in the low two-percent range and most line-of-credit’s being offered at three or four-percent, this is truly an unprecedented time for borrowing cheap money.

The argument to pay off debt during periods of low interest rates is that more of your payments are going towards principle and less is going towards interest.  A $300,000 mortgage at 2.25-percent amortized over 25 years would require a $1,300 monthly payment, with $750 of your first payment going towards paying down the principle and $550 covering the cost of interest.

If we use the same mortgage terms but increase the interest rate to 5 percent, things look a lot different.  The total monthly payment shoots up to $1,750, with only $525 paying down the principle and a whopping $1,225 covering the cost of interest on your first payment.

Low Interest Rates – Invest Your Money

Many investors prefer to borrow to invest during periods of low interest rates.  The theory is that they can generate a higher return with their investments to offset the cost of borrowing the money.  With some good quality dividend stocks and REITs yielding between four and seven percent these days, investors can potentially profit by borrowing to invest.

There are similar investment strategies when interest rates are low.  Rather than borrowing to invest, you can simply make the minimum payments on your debt and use the extra cash flow to invest in stocks or real estate.  When interest rates go up, you can reverse this approach and use the extra cash flow to pay off debt.

What Should You Do?

Everyone’s situation and tolerance for risk is different.  If you have a high mortgage or line-of-credit balance, the prudent thing to do would be to take advantage of low interest rates to pay off debt.  With a mortgage, the cost of borrowing is amplified in the first 5 years by the amortization schedule, so making additional principle payments in the first term will further reduce the overall cost of the mortgage.  If you are locked into a fixed rate, it also makes sense to look into refinancing your mortgage to save money.

Affordability is the key, so if you have your debt levels under control and are comfortable with the extra risk, borrowing to invest or freeing up extra cash to invest with can help build up your assets in a hurry.

We just built a house and took out a fairly large mortgage with a variable interest rate.  I love the fact that economic indicators are pointing to a longer period of low interest rates because I plan on doing some heavy damage to our mortgage in the next five years.  I’m paying an additional $500 per month on our mortgage, which will reduce our principle by more than $30,000 over five years.

With low interest rates here to stay for a while longer, are you focusing on investing or will you pay off debt?

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