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I am looking for a method to calculate - or estimate - whether it would be better to pay off car debt or start value investing in stocks.

My history:

We are soon to get about 1900 USD/month in excess cash (due to new job and refinanced mortgage), and we are targeting to invest in real estate at some point. It takes a lot of saved cash to persuade the bank. In 1½-2 years from now, just saving the extra cash, we would definitely be able to start investing in real estate.

But - what to do in the meantime? In our bank, we have an account with a 5% loan partially for financing our house. Any excess cash saved on this account (until we have saved as much as we owe) will counterbalance the interest - i.e. if we owe 50,000 USD but have saved 30,000 USD, we'll only pay 5% interest rate for 20,000 USD. So that is in essence a guaranteed 5% return. However, if I started (value) investing in stocks, I might hit 10-15 % return. But if we need the cash in 1½-2 years from now, it seems to contradict the old advice of buying and holding for 10+ years.

Another approach I have considered is to pay off our car (3.95% interest rate). This can be done in 14 months and will release about 455 USD/month and increase our cash flow. Some would argue that it would make better sense to keep the debt and then invest instead. However, the car will only drop in value over time, whereas a house (for instance) should at least keep its value - and hopefully increase (so it's inflation resistant). Anyhow, this would have us wait another year to invest in real estate.

I know this question could invite to subjective opinions, but is there any definite way to calculate/estimate what would make the most sense - financially?

Total debts:

  • Hereof car: 34,500 USD (3.95%)
  • house/mortgage: 251,000 USD (1% adjustable) + 47,000 USD (5%)

Total debt is ~330,000 USD

I do not yet have "emergency fund", but we have a sort of insurance.

Also, 17% of my salary before tax (a little less for my spouse) goes to a pension fund - this is on top of our actual salaries.

Additionally:

There is a ceiling on the mortgage (approx. 1.75 %) that it cannot exceed for the next 6 years. There is 8 years left on the car loan, 10 years left on one of the loans in the house (the 5% one), and 30 years on the other (the 1% loan - but only the interest is paid the first 10 years).

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    Paying off the highest debt rate first will be a more reliable way to provide you with more discretionary money. There is no definite way to calculate/estimate what would make the most sense because the future market gain of an investment is unknown. "I might hit 10-15 % return". Yes, and could could also hit a negative 10-15 % return. You can see the possibilities by setting up a spreadsheet and varying the return input (-15, -10 ... +10, +15, etc.). Then place your bets... – Bob Baerker May 24 '18 at 12:15
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    "money thrown in the trash" no - it's paying back money that you borrowed to buy the car so it is also "buying an asset", just in arrears. If you're tired of throwing your car payment away then sell the car. – D Stanley May 24 '18 at 13:47
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    Is that 1% on the morgtage correct? That is an insanely low rate. Is that 1% fixed or ARM? – Freiheit May 24 '18 at 14:12
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    @Freiheit IMHO an IRA should be on everyone's radar. – TTT May 24 '18 at 16:32
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    @pseudoninja so why did you quote your finances in USD? – Tom W May 24 '18 at 16:35
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Financially, it is a trade-off between risk and potential reward. Yes the equity market might make you 10-15%, but in a year the return could be anywhere between +40% and -40% based on past history. Are you able to handle that much swing? Plus how certain are you in your "value" investing skills? Are you willing to put that much faith in your own skill as a value investor? What do you know that the market doesn't?

Paying off the car loan is a guaranteed 4% return, which you cannot beat in any type of risk-free investment right now. Plus, there are other benefits. It will be easier to sell the car with no lien, and once it's paid off you can use that payment amount to pay down the other 5% loan or accelerate your investing.

Same goes for real estate. Yes the value of the house might grow and/or you might get rental income, but what if it goes unrented for 6 months? What if the A/C goes out and it costs you 4 months rent? What if you have tenants that tear up the house or are always late on the rent? There is significant risk in real estate as well.

If it were me, I would use the money to pay down the car without hesitation.

that 1% mortgage is correct, though it's a variable interest rate

Then I would even more strongly pay down other debts. When that mortgage resets, there is a strong change that rates will be higher, and your payment could increase significantly. You will need as much cushion in your cash flow as possible to be able to handle that increase, and reducing your debt payments is a great way to do that. You do NOT want all of your cash flow tied up in other debt payments in that scenario, or you might lose one or both houses.

  • By proper research, the risks associated should be small. Where I am we don't use A/Cs, and the tenant actually is required to do much maintenance himself. – pseudoninja May 24 '18 at 14:52
  • Oh by the way, we should be able to handle such swing. The money is in excess, even after we save for dentist appointments and vacation. There is, on the other hand, a great chance that my spouse spends 100% of it on rubbish ;) – pseudoninja May 24 '18 at 15:04
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    @pseudoninja A/C is just an example. You can replace it with heat, or the roof, or a bedbug infestation, or a fire. There are lots and lots of things that can go wrong while renting. – Kat May 24 '18 at 17:20
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    @R.. Let's not be too literal - the point is that there are costs (both planned, like insurance, and unplanned, like A/C) associated with rental real estate that eat into the returns. – D Stanley May 24 '18 at 18:03
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    @pseudoninja: What Kat is saying is that there are risks to consider, even in buying real estate. Your response is, in essence, "I've covered all risks". As an engineer, let me unequivocally state, no, there are always more risks that you haven't thought of. Whether those risks are bad enough to no invest is up to you, but they are present. – sharur May 24 '18 at 21:49
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Here is the "debt snowball" approach with one adjustment because of the extremely low mortgage rate.

First save up for an emergency fund. Even if you have insurance to cover that, you'll be better off having cash on hand to pay up front then ask for reimbursement. There may also be deductibles or co-pays to cover with whatever insurance you have. If you have the money in your bank you can just pay for problems and not have to use insurance or loans against the house.

Use the extra income to pay off the car loan. You've effectively earned 3.95% a year without asking the bank for a loan or doing the work behind real estate investing. You also now own the car outright and if times get really tough you can sell it outright without having to pay off the loan.

Once the car loan is paid off, pay off that $47,000 note on the house. You've effectively earned 5% a year without asking the bank for a loan or doing the work behind real estate investing.

The 1% mortgage is debatable. You can current get a 1% return having money sitting in a good online savings account. Beating 1% with even very conservative investments is easy.

You are in an astonishing financial position. Get your debts paid off and you'll be free to save or invest your extra earnings as you see fit and not be beholden to anyone. If you have the cash flow or your own savings you will not need to please the banks before executing your real estate investment plans.

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    Dumb question maybe, but wouldn't paying off the 5% on the house be greatly preferred? I get that some people go for 'pay the smallest debt to increase the cashflow', but it's not like the car debt is vastly smaller than the house one. Also, if things go wrong, it's pretty common to take out a new mortgage on a house, whereas taking out a new loan on an old car would be difficult/expensive. Edit: Also, the 5% loan appears to have an 100% offset set up. This allows OP to build an emergency fund that can be instantly drawn down on, and earn 5% tax free on it. – Scott May 25 '18 at 5:05
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First of all, although it may seem that putting amounts in terms of USD is a convenience for US readers, you avoid giving the impression that you have dollar-denominated debt. You could say "USD equivalent" instead. Having a debt that is equivalent to a certain amount of dollars is significantly different from owing that particular amount of money. If the exchange rate between USD and kroner/Euro/whatever it's denominated in changes, then the amount you owe from a USD perspective will change.

Choosing between paying down mortgage and buying stocks depends a bit on risk preference. The higher stock returns are based on the uncertainty of the stock market. Part of your mortgage interest is also based on uncertainty: the bank is charging you interest based on uncertainty regarding whether you will default. It's charging you more than what it would charge if it knew for certain you won't default, and less than if it knew for certain you will. While the stock market uncertainty is shared across investors, and you do not have any advantage over anyone else, your uncertainty regarding your loans is much lower than the bank's. If you think you will default, then the loan is underpriced, and you shouldn't pay it off. If you think you won't, then it is overpriced, and you should pay it off.

The above applies just to the 5% part; I don't know how you got a 1% interest rate, but this is almost certainly underpriced and should not be paid off unless you have absolutely nothing else to do with your money.

However, the car will only drop in value over time, whereas a house (for instance) should at least keep its value - and hopefully increase (so it's inflation resistant).

That is completely irrelevant, unless you're planning on defaulting on the car loan and are worried about its liquidation value, or something along those lines. The depreciation on the car is a sunk cost; neither paying off the mortgage nor paying off the car loan will affect the depreciation.

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Pay off the debt first

It is going to be highly unlikely that the cost of a mortgage is going to be less than the typical investment you may find at a bank. After all the banks have to make money somehow and the basic concept of asking more interest for loans than what they provide for investments is the main way how they do it.

As for the equity market, I would advise you to be wary of over-committing to it. The risks are massive and you can very easily lose all your money in it, I would not have more than maybe 10 - 15 percent of your investments tied in it.

  • I agree with everything you said except the % equities. I've had 70% of my savings in equities for 25 years, with the remainder being in CDs. This year I've reduced equities to about 40% for the first time ever. For someone starting out, its important to learn the equity market. If you are afraid of armageddon, buy quality that will do well during armageddon like GNRC, SRCL, HUM, JNJ, BUD. Otherwise if you don't enjoy doing research just buy VFINX and IWM. – Keith Knauber May 29 '18 at 17:14
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In the U.S., there are tax deferred retirement accounts you can contribute to. (I assume other countries have retirement plans) You immediately save a whopping 20 - 33% on income tax, which far outweighs interest paid on a 5% car loan.

A simple example of contributing max of $18,000 to a 401(k):

  • at least 20% off of income tax: defer $3,600 in tax (until retirement)
  • payoff $18,000 loan at 5% interest: save $900

Contribute the max to either your 401(k) or an IRA (you may be able to contribute to both in the same year if your income isn't too high.).

Myself, I bought a car last year, got a loan, and quickly made about 15% on the money that I didn't pay off the loan with. However, this year, I've payed it off, and moved more than half of my investments into a money market ETF (MINT) that pays < 2%.

So my personal opinion today would be no, don't invest in stocks or even bonds in an environment where Fed is raising rates. Its better to pay off the loan.

However, definitely yes if you can contribute to a tax deferred account, buy a money market ETF, wait for 2 to 3 years for market to crash, and then slowly move the money into stocks over time as they become cheaper (especially when fear is at the highest)

  • According to the comments, OP does not live in the U.S. Also, in your last paragraph, which question does “no” and “yes” refer to? – Ben Miller May 24 '18 at 18:00
  • Generalizing this advice for any country would make it a good answer. Like even if OP cannot use a 401k or IRA, there might be tax deferred investment options or private retirement funds to invest in on top of the pension. – Freiheit May 24 '18 at 19:35
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    @Freiheit Incorrect information anyway, saying that you save 20-33% instead of defer... Plus most otherwise eligible people probably can max both a 401(k) and an IRA, depending on earnings. – user3067860 May 24 '18 at 21:37
  • good points, I've edited answer to make more clear. – Keith Knauber May 29 '18 at 17:15

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