Does it make sense to compare the "returns" from debt payoff with long-term stock market investment returns?

Question

I've been thinking long and hard about whether to pay off my student loans with the smaller interest rates as quickly as possible or just pay the minimums and start investing.

After reading bunch of articles examining that topic, almost all came out saying you should invest and just pay the minimums on the lower interest debt, and the main reason is because they said the expected returns from the stock market are around 7-9%(ish).

But in the debt-payoff-first scenario, I'd be wiping out my debt in two years. It would take several more years if I were to just pay the minimums and put the extra money toward investing instead.

Given that short time frame, it doesn't seem relevant to be comparing the long-term returns of the stock market to the amount of interest I'm paying. In two years it seems impossible to estimate the returns given the volatility of the stock market.

Or, since I'd be leaving the money in the stock market until retirement, would that make it the better choice?

And this is a separate (but related) issue, but since bonds seem to return roughly the same or lower than my student loans (around 3.5% to 4.5%), if I'm going to be using that extra money to invest it shouldn't be in bonds, correct? That seems obvious but I've only heard you should invest in both stocks and bonds for diversification purposes.

Answer 1

"But in the debt-payoff-first scenario, I'd be wiping out my debt in two years. It would take several more years if I were to just pay the minimums and put the extra money toward investing instead."

Right. The idea is that in 2 years, you are likely to have more in the savings/stock account than you owe on the loan. But. The range of returns for X years has a smaller standard deviation the greater X is. e.g. any year has about a 1 in 3 chance of being negative. A 10 year period had a negative return (-1% CAGR) in the '00s recently, but the 15 year return even around that decade would have been successful. Jan 1 '96 - Dec 31 2010 returned 6.76% CAGR, Jan 1 2001 - Dec 31 2015 returned 4.96% CAGR.

This tells you that the time frame is as important as your sleep factor. Your 2 years? I'd just kill the loans. A 10-15 year horizon? I'd ask how you "feel" about that debt. The cost of going after a potential higher return may not be worth the risk to many. For some, it's fine. I retired, with a mortgage still in place, but the money in my 401(k) that could have paid off the mortgage is now about twice the remaining balance. So I sleep like a baby.

In the end, I'm a fan of investing for the long term vs paying off low rate debt, but it's a choice based on the individual.

Answer 2

they said the expected returns from the stock market are around 7-9%(ish). (emphasis added)

The key word in your quote is expected. On average "the market" gains in the 7-9% range (more if you reinvest dividends), but there's a great deal of risk too, meaning that in any given year the market could be down 20% or be up 30%.

Your student loan, on the other hand, is risk free. You are guaranteed to pay (lose) 4% a year in interest.

You can't directly compare the expected return of a risk-free asset with the expected return of a risky asset. You can compare the risks of two assets with equal expected returns, and the expected returns of assets with equal risks, but you can't directly compare returns of assets with different risks.

So in two years, you might be better off if you had invested the money versus paying the loan, or you might be much worse off. In ten years, your chances of coming out ahead are better, but still not guaranteed.

What's confusing is I've heard that if you're investing, you should be investing in both stocks and bonds (since I'm young I wouldn't want to put much in bonds, though). So how would that factor in?

Bonds have lower risk (uncertainty) than stocks, but lower expected returns. If you invest in both, your overall risk is lower, since sometimes (not always) the gain in stocks are offset by losses in bonds). So there is value in diversifying, since you can get better expected returns from a diversified portfolio than from a single asset with a comparable amount of risk. However, there it no risk-free asset that will have a better return than what you're paying in student loan interest.

Answer 3

The rate difference between your student loans and the historical yearly average growth in the S&P500 isn't large enough for me to play the "pay minimums and invest the rest" strategy. If your loans were 2%, I might think about it.

However, the 4% loans are guaranteed and mandatory expenses; discharging them even in bankruptcy is unlikely. The quicker you pay them off, the sooner you won't have them hanging over your head in case of a "financial setback" (job loss, large expense uncovered by insurance, etc).

(One good reason to pay the minimums, though, is to build up a $1K emergency fund. When your debts are paid, then you can increase its size.)

Answer 4

It is difficult to actually 'answer' your (or any other) investment question as investment outlook and objectives are different from one individual to another. I shall put down some of my thoughts and probably you shall be able to factor them in while you take your decision.

1. One way to wealth creation is investment in instruments for long term. One reason for this is in long term the volatility of instruments are evened out and a reasonable mean return (in your case 7-9% extimated) is realized. If the above reason is considered (different people have different views), then it would be better to invest as much as possible and as early as possible.
2. During individual investment, it is seldom that a person has all the investment capital needed at any time. Capital is accumulated (probably monthly) and deployed. Alongside point 1 above, more outlay per time period is better than less outlay.
3. The quantum differential in a way can be somewhat estimated. Take the saving in capital if you pay the minimum amount, for 2 years, compound the capital with 7% for 30 years. You will have some idea how much the impcat of the capital will be

As for your last paragraph, in general from investment perspective, the younger you are more kisk you can take and bond gives a stable base to a portfolio. One good way to estimate the proportionality of bond:stock is (your age):(100-your age). However for 2-3 years you could ignore the above and invest in good quality stocks for long term.