How to pay back your loans optimallyJun 8, 2020
The two primary methods for paying off debt that are often discussed in personal finance circles are the Snowball method and the Avalanche method. Neither is the optimal strategy for maximizing your wealth.
The Snowball is supposed to make it psychologically more rewarding to repay debt by paying down the smallest loan accounts before the larger ones.
The Avalanche is a more efficient approach that ignores the absolute amount of any particular loan account and has the borrower focus on paying down higher interest rate loans first, thus saving much more money in the long run when compared to the Snowball method.
There is a better way!
When thinking about paying down debt, consider the other options you have for the money first. Once you pay down a loan you lose the option to invest that money in the stock market. (Or, in yourself!) You should compare the expected rate of return on the investments available to you before you choose to pay off a debt, particularly lower rate loans like a mortgage or a subsidized undergraduate loan.
The most widely accessible (and measurable) option is investing your money in an index fund. As of writing the Vanguard Total Stock Market ETF (VTI) has returned 7.12% annually since its inception in 2001. In the past year it has returned 11.46%. This means that if you were to borrow money one yar ago at 5% and have invested it in VTI, you would be able to keep the excess 6.46% for yourself!
To make that a little more real, imagine you have $32,000 of undergrad student loans at 5.4% (this is pretty much the average) and just landed your first job out of college. You're making enough to pay an extra $500 toward your student loans each month. Should you do it? Historically, (and in spite of what most Personal Finance for Millennials books will tell you) the odds are in your favor if you don't! The optimally prudent strategy here is to invest the money and enjoy the difference between the interest you're paying and the return you're earning in the market.
This comes with risks, though. You know with certainty you will need to pay 5.4%, but the market could tank this year and leave you with less money than when you started. And if you choose to do something else with the money you set aside like buy a car, take a class, or start a business, then it's harder to compare the utility of what you bought to the return from other investments or personal happiness you got from a purchase.
In my opinion, a great way to approach this strategy is to create an investment account (I use Betterment) that is associated with each major type of debt. (student, mortgage, auto) Then, instead of pre-paying those loans, make contributions to the investment accounts associated with them. Once you've built up enough money in that account to match the loan, you can come back to the account every six months or so to move any excess money and use it wherever you like.
This strategy works particularly well for mortgages. After deducting interest, I have seen the effective APR get as low as 1.9%! Pre-paying debt that cheap when better investment opportunities abound would be madness.
- You can't fool around with this strategy. If you spend the money you set aside to match a particular debt, you're back to square 1.
- Your investments will lose you money some years. While this strategy is a good bet on average, sometimes you lose the bet, and your portfolio will be down a bit. Don't worry! Just contribute some more to get the balance back up.
- You will likely end up with more money.
- You preserve the option to sell your investments and use the proceeds if a sudden need arises.
In this example, a borrower has two loans for different amounts at different rates. The borrower expects to be able to get a 7.12% return on investment, and has $800 per month available.
At the end of the two years the borrower would see the following total cash flows from interest payments and return on investment. Both Avalanche and the strategy proposed here of investing to offset debt vastly outperform the Snowball method, and, given the assumptions we used above, investing can improve your outcome by a meaningful amount.