When Interest Rates Are Low Should You Pay Off Debt Or Invest?

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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  1. My Own Advisor on August 17, 2011 at 7:41 am

    Nice post.

    I’m taking a two-pronged approach, paying down debt and investing, although I’m definitely not borrowing to invest. The theory is great, but the reality is, you cannot control what the markets/equities will or won’t do. At least I can’t.

    Paying down debt is guaranteed and within your control. I prefer the sure thing more often than not when it comes to personal finances and investing.

    • echo on August 17, 2011 at 11:01 pm

      @ My Own Advisor – I think it’s smart to do a bit of both. While I really want to kill my mortgage debt quickly, I know I’ll be missing out on years of compound growth if I ignore my investments now.

  2. Simon on August 17, 2011 at 9:05 am

    I hear what My Own Advisor is saying but I AM borrowing to invest as I am comfortable with the risk but invest very cautiously and only on downturns which there have been a few due to the volatility.

    Rather than using the dividend income to buy more stocks, I use it to pay off the loan. I consider paying the loan off a risk-free 4% investment.

  3. Eric Putnam on August 17, 2011 at 11:20 am

    I agree with My Own Advisor. Markets can be voliatile as we have seen and no idea of when -not if-borrowing rates will go up remember you get a guaranteed return if pay off debt -take interest rate on debt multiply by marginal income tax rate to determine your true return.

  4. krantcents on August 17, 2011 at 12:28 pm

    As an old(er) person, I am more risk adverse so I am not borrowing to invest. Now is a good time to pay down debt because the alternatives for investment are also low yielding.

  5. Bill Birnbaum on August 17, 2011 at 7:28 pm

    Seems to me that, baring a recession, investing in the way to go. For investing low-cost borrowed money offers the advantage of leverage at low cost. Of course, there is a risk. Just maybe we’ll fall back into recession. In that case, most investments will do poorly. Bill

    • Echo on August 23, 2011 at 3:58 pm

      That’s a good point. I think that’s why so many people have been successful in real estate. Leverage amplifies the gains when you’re dealing in hundreds of thousands.

      Of course, it amplifies the losses as well…

  6. My University Money on August 17, 2011 at 9:51 pm

    Why not do both with the Smith Manoeuvre? Pay down your mortgage at the low interest rate, re-borrow it again with a HELOC and invest it. This way you can quickly convert your mortgage into tax-deductible debt, and have your investments in place for when the economy starts to hum again and interest levels rise.

    • Echo on August 23, 2011 at 4:05 pm

      @My University Money
      I would never consider using the Smith Manoeuvre for a number of reasons. How many people who got caught up in that craze 3-4 years ago still have their SM intact? Only investors with iron stomachs could have watched their leveraged portfolio drop by 40-50% and still hung in there for the recovery.

  7. The Passive Income Earner on August 18, 2011 at 1:59 am

    I find that playing with the mortgage can be a risky business depending on your situation. As a home owner, you have the following options:
    1. Keep Payments & No Investments (Cash is tight)
    2. Increase Payments & No Investments (Debt free goal)
    3. Keep the Payments & Do Investments (Net worth goal)
    4. Increase Payments & Do Investments (Obviously you have the cash)
    5. Refinance To Lower Payments & Do Investments (Ballsy!)

    When interests are low, borrowing more money means you also have to service more debt. It’s not necessarily good on cash flow since dividends can be quarterly and payments are monthly. Even if the math on your dividend income work out. Wealthy leverages money to move ahead but don’t forget that they also have positive net worth as opposed to negative. For example, they would borrow for a down payment and mortgage on a real estate deal at the current rates rather than sell investments (generating more than the interest). Often time, I find, as My Own Advisor points out, that the fixed rate and predictability of my savings on my mortgage is far greater than potential earnings of an investment. Especially if you don’t have the cash flow to service the extra loan.

    A question I ask to test if paying your mortgage is more important than investing is the following. Assume you have 10 years left on your mortgage. Are you ready to refinance for 15, 20 or 25 years in order to invest the difference of your payments? Consequently, if you grow your nest egg, at which point do you pay your debt in whole?

    @My University Money
    I am not sure how the Smith Manoeuvre plays in deciding where to put extra cash. Wouldn’t you be better to put the extra cash in an investment and use the dividends to accelerate the Smith Manoeuvre? Otherwise, if you just put it on your mortgage, your extra cash only accelerate converting loan X to a tax-deductible loan X. From a loan perspective, you owe the same amount of money, what change is how much is tax-deductible. If you invest it outside, you grow your nest egg further. A tax-deductible loan is still a loan with interest … The next question is, which compound growth is better; re-invest your dividends or accelerate your Smith Manoeuvre. I think I got to make some spreadsheets and maybe write a post now …

    • Echo on August 23, 2011 at 4:08 pm

      @The Passive Income Earner
      Great response, thanks! I think that the first 5 years of your mortgage are the most critical if you are going to take a big bite out of it with extra payments. That’s the path we’ve chosen, and after 5 years I will re-evaluate our amortization schedule, investments, economic indicators and income situation to determine what we’ll do with the next 5 years.

  8. The Wealthy Canadian on August 21, 2011 at 9:19 pm

    Within my personal investments, I have prioritized paying down my HELOC on my rental properties but I still keep some of my funds for RESP, RRSP and TFSA contributions.

    In my holding company, I’ve been focusing exclusively on equities lately and my debts are short term in nature. Interest rates on GICs and other guaranteed vehicles are at very low levels at this point in time.

    It doesn’t seem as though interest rates are heading upwards any time soon; however, borrowing to invest should not be justified based on rates alone IMO.

    Nice post!

  9. Value Indexer on August 27, 2011 at 9:58 am

    Good post and comments! I like to consider this decision based on the long-term networth results. Since our mortgage rate came from a hold placed at the low point last fall, there’s more than a fair chance that investing could yield a higher return. But guess what happens at the end of 5 years – that mortgage balance renews at a higher interest rate! So the rate of return from paying down the mortgage actually increases.

    And I recently calculated that just taking the maximum monthly payment increases for the first 5 years and then holding steady at that level would result in paying off the mortgage in 10.5 years, so I need to figure out the potential benefit of having extra cash to invest after that.

    If you’re absolutely sure you’ll get paid a lot in the near future then low interest rates are a good deal to let you access it sooner. Since my income is from my business I tend to eliminate debt and build un-leveraged assets.

    Until I can figure out the future I’ll balance my bets, doing a little bit of everything with some extra cash going towards what seems like the best long-term return.

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