Evaluate your debt before making the investment
Yes, it's true, paying off debt is boring, but it makes it easier for you to make investment decisions. Instead of spending a lot of time looking at special investments, great pay off your debt first (if you have debt) because that is the best low risk investment that also saves a lot of money. Compare the interest you pay with the return your investments yield and decide which debt to pay off first.
The victory over consumer credit
Many people have debt in their checking account, a car loan that they have to pay 8,10, 12 or even more percent interest on. When you pay off this debt, it's like investing your savings at the interest rate you have to pay. And you don't have to pay taxes for that. For example, if you have to pay 15 percent interest for overdrawing your checking account, then balancing the account is equivalent to investing capital with a 15 percent return, on which you pay no taxes. Because interest on consumer loans can't be claimed for tax purposes, you need to earn more than a 15 percent return to get to 15 percent after taxes. Such high returns are unlikely to happen. And even if you have such an opportunity, it comes with high risks.
Consumer loans jeopardize your financial health in the long run because they put a strain on your future income. Often I hear people say, "I can't afford to pay cash for a new car – it's just too expensive! True, new cars are expensive. So temper your claims and buy a good used car that you can afford to buy. Then you can invest the money you would otherwise have to spend on the loan.
Bank overdrafts, car loans and the like are the most expensive debts to take on. Banks and credit unions charge higher interest rates on consumer loans than on investments, such as real estate or business startups. The reason: consumer loans carry the highest risks for banks.
But consumer loans make sense if you're investing in your small business. If you can't encumber your home, personal loans may be the least expensive alternative (read more on our financial portal). Once again, to make it worthwhile, the return must be higher than the interest to be paid.
Pay off mortgages
It also makes sense to pay off mortgages early or make unscheduled repayments if your contract allows it. If you sign a new mortgage contract, make absolutely sure that the mortgage bank gives you this option. However, this financial move is not as clear-cut as repaying consumer loans with high interest rates, because mortgage interest is lower and can be deducted from taxes as a business expense for rented properties. If you use debt the right way, it can help you achieve your goals – buying a home, starting a business – and make money in the long run. Taking on debt in order to use it to buy real estate usually makes sense. In the long term, you can expect real estate to increase in value. If your financial situation has changed or improved, then you need to think about how much more you want to charge your property. But even if your income did not rise or you did not make a large inheritance, you can redeem faster than necessary. Whether it makes sense depends on a number of factors, including your goals and other options for investing your money.
Investigate other investment options. Compare your mortgage rates with the return on investment of the alternatives. The difference determines whether you pay off the mortgage faster (but check your contract first to make sure you don't have to pay a prepayment penalty). Let's assume you are paying mortgage interest at the rate of 8 percent. If you choose to invest, it must yield at least eight percent before taxes for you to have an advantage.
Apart from the fact that you often don't have the money, there are other reasons not to pay off your mortgage early:
✓Your contract does not allow unscheduled repayments without an early repayment penalty or only limited unscheduled repayments.
✓You want to make special payments into your pension plan because you have gaps in your insurance history.
✓You want to pay into a private pension plan because you want a better standard of living in retirement and you can't get by on your state pension.
✓You are not subject to pension insurance because your income is above the income threshold or you are self-employed. Therefore, you want a different financial security for retirement.
✓They want to get into growth-oriented, more volatile investments, such as stocks or real estate. For you to have a real chance of making more money than you pay on your mortgage, you need to invest aggressively. As we said in our financial portal, stocks and real estate yield eight to 10 percent annual returns. You can earn even more by owning your own business or an equity interest. Some investors use leverage (they borrow money to be able to invest more). Paying off mortgages ties up your capital and reduces your ability to make other attractive investments. For more aggressive borrowers, paying off mortgages is as boring as watching paint dry. Note, however, that there is no guarantee of profits from growth-oriented investments. You can also suffer losses of 20 percent within one or two years.
✓ Mortgage repayments can eat up your nest egg. There are people who do not feel comfortable paying off mortgages faster because it would raid savings and other investments. You might refrain from paying off mortgages because it depletes your reserves for emergencies. Make sure you park at least three months' worth of living expenses in a money market account or tap other sources of money for that time (family, friends).
Finally, do not succumb to the misconception that if the real estate market collapses, you will hurt yourself if you pay off the mortgage early. Your house has its value – and it has nothing to do with the amount of your debt. If you do not plan to dive and send the house keys to the bank, then you suffer the full loss of value, no matter how high the mortgage debt, if the property prices collapse. Do not fall into the trap of mortgage interest being tax deductible. It is true that mortgage interest is deductible, but this only applies to rented properties. Pur the profits from renting and leasing you have to pay taxes. You could also buy municipal bonds, but they don't bring a higher return than you would have to pay for a mortgage. Other investments such as savings accounts, certificates of deposit, and bonds are also unlikely to yield better returns.