Start With the Numbers, Then Consider Your Mindset

There may be psychological factors that determine if you invest extra money you have or pay off debt faster. But knowing the difference based purely on numbers should guide your thinking as well. Follow the steps below to understand the impact.

1. Calculate the Total You Would Save in Interest Payments:

The faster you pay down your debt, the less you’ll pay in interest – but you’ll do so at the opportunity cost of potentially earning more had you invested that money instead.

1. 1. Use this loan calculator from Bankrate.com and note the “Total Interest Paid” calculation. To use the calculator you’ll need to know your current total balance, the remaining number of months on the loan, and your annual interest rate (i.e. your APR).
   2. Now click “Add Extra Payments” and enter the monthly extra payments you plan to apply (or enter the one time payment amount). Make a note of the new “Total Interest Paid” calculation.
   3. Subtract the original “Total Interest Paid” from the new “Total Interest Paid.” This represents the total amount you will save by applying extra payments to your loan. 
   4. Note this final number as your “Interest Savings” number.

2. Calculate Your Possible Investment Earnings:

1. 1. Use this compound interest calculator from Investor.gov.
   2. Enter “$0” in the initial investment field (unless you have a one time payment you are planning to apply to your debt or invest).
   3. In the “Length of Time in Years” field enter the loan term. 
   4. In the “Interest Rate” field enter your expected annualized rate of return. We suggest 7%.
      
      (Remember the while the average long-term annualized rate of return for the S&P 500 Index fund is between 10 and 11%, there is huge variability year to year. The shorter the time horizon, the lower your confidence should be in any particular rate of return. Additionally, after inflation, some have calculated the average rate of return closer to 7.5%. To keep things simple and conservative, if you have a time horizon of at least five years, use 7% but know that your actual return may be better or worse.)
   5. Click “Calculate.”
   6. Hover over the graph and subtract the difference between your total contributions and the future value. This represents your possible total investment earnings. 
   7. Note this final number as your “Possible Investment Earnings” number.

3. Subtract the Difference Between Interest Savings & Investment Earnings

1. 1. Take the final number from step one and subtract it from the final number in step two. This number represents the amount you would benefit by investing vs. paying off debt at respective interest rates.

A Note on Taxes

If your earnings will be subject to Federal income tax, you can subtract an additional 10 – 37% – based on your effective tax bracket – from your earnings number. This will give you a closer estimate of the true value of your investment earnings number. To find out what your marginal tax bracket is, search the web for “marginal tax rates” and compare that to your income. You can also search for your state tax rates too if you want to get even more precise.

If you choose to go the route of paying off debt early, whatever you save on interest by paying off early will never be taxable so you don’t need to worry about this.