[Kaggundi]

Pay off Home Loan Vs Invest. What are the criteria for taking the decision?

[ArcSine]

The first step is to compare the interest rate on the loan with the rate(s) available to you on whatever investment alternatives you have; then choose the highest. But before pulling the trigger based solely on this first-pass calculation, recognize that there is a series of adjusting factors you'll want to apply in order to fine-tune the answer. How far you go with the refinements is up to you. Finally, you'll take into account various situation-specific factors which might affect--or even override--the purely mathematical answer.

Back to Step One. The economic benefit of using $1 to pay down a loan, when the loan bears interest at X%, is identical to investing that same dollar at X%. Here's a very simple example:

I have an extra 100 bucks which I can either invest at 7%, or which I can use to pay down a loan I currently have outstanding. The loan matures in one year, has a face amount of $500, and bears interest at 7%.

If I invest the $100, then one year from now I will (1) have an investment that pays me $107; and (b) will owe $535 to pay off the loan. Using the $107 investment proceeds to help pay off the loan, that leaves me needing to write a check for $428 to finish paying off the loan.

On the other hand, if I just use the $100 today as an early pre-payment on the loan, the balance of the loan immediately drops from $500 to $400. Then one year from now, I'll owe $428 when the loan matures. Identical results.

This principle holds true for more realistic, real-world situations, such as a home loan with monthly payments, etc.; but a rigorous proof would take more typing and reading than either one of us would care for! :)

So Step One is to compare the interest rate on the home loan with the rates you have available from the investments you're considering, and choose the highest. That's where you get the biggest economic bang for the buck.

Refinement One (and at a bare minimum, do this one!): Take into account the after-tax rates on the loan, and on the investments, before deciding which one is "highest". Your tax advisor should be able to provide those numbers. It's the after-tax rate of return on an investment, and the after-tax effective interest rate on a loan, that counts.

Another refinement is to consider the relative risks associated with each alternative. I'd strongly urge solciiting the advice of an investment advisor on this one. An investment promising an 8% return, say, but which involves many uncertainties and unknowns, is NOT equivalent to an 8% home mortgage loan. The "risky" 8% investment should more correctly be evaluated in Step One at something less; it might be 6%, or 4%, or... your investment advisor can help you make that adjustment.

Finally, DO consider the other factors surrounding your particular situation. It might, for example, be wise to choose "loan paydown" even if the above procedures suggest otherwise. You might need to enhance your credit score, e.g. For someone on a fixed income, the security of simply having a reduced monthly house payment might far outweigh any purely economic evaluations. So please consider very carefully all the qualitative issues attendant to your particular circumstances.

I hope this helped just a bit, and best of luck!

[morgaine300]

Another refinement is to consider the relative risks associated with each alternative. I'd strongly urge solciiting the advice of an investment advisor on this one. An investment promising an 8% return, say, but which involves many uncertainties and unknowns, is NOT equivalent to an 8% home mortgage loan. The "risky" 8% investment should more correctly be evaluated in Step One at something less; it might be 6%, or 4%, or....your investment advisor can help you make that adjustment.

Personally I would take this one into serious consideration. Keeping in mind that an investment advisor could easily have his or her own interests at heart. If you want advice, I'd go to an independent financial advisor who gets a set fee for the advice and not a commission for the investments they get out of you.

If you want some free advice, you can either call or email here:
ClarkHoward.com Home: Save More, Spend Less and Avoid Rip-Offs on clarkhoward.com
I know not everyone is going to agree with him all the time, but he does know his stuff pretty well and this is exactly the kind of thing people call and ask about. If you email, you can give all the personal info in confidence, if you don't like blabbering about your interest rates to the entire world.