Comparing Yields on Various Types of Personal Loans: Should You Pay Off or Invest?

Oct 20, 2024 | 401K, 401k loan, Credit, Debt, Feature

Comparing Yields on Various Types of Personal Loans: Should You Pay Off or Invest?

Loans are a big part of managing your money, and it’s important to get a handle on how their interest rates work so you can make smart choices. Whether you’re buying a house, getting a car, paying for school, or just covering your expenses, it’s all about knowing when it’s okay to borrow, when to focus on paying things off, and what to do with any extra cash. Don’t forget—sometimes safe investments like Treasury bonds or short-term bond funds might be a better option for your money than paying down certain types of debt if those debts’ interest rates are lower than what’s paid by these safe bond investments!

Let’s explore the common types of personal loans—mortgages, credit card debt, car loans, student loans, and other personal loans—and discuss when paying off loans makes sense compared to safe investment options.

Loan Types and Their Yields

1. Mortgage Loans

  • Yield Range: 2-7% annually
  • Purpose: Used to finance the purchase of a home.
  • Features:
    • Mortgages tend to have the lowest interest rates among personal loans, especially with a fixed-rate, 30-year term.
    • Interest may be tax-deductible.
  • Consideration: With low interest rates, paying off a mortgage early often isn’t necessary, particularly if you can earn more by investing elsewhere. However, the funds you have allocated to pay off the mortgage should not be touched for other purposes, as it ensures your ability to meet future obligations.

2. Credit Card Debt

  • Yield Range: 15-25% annually
  • Purpose: Typically used for everyday expenses, emergencies, or convenience.
  • Features:
    • Credit card debt has one of the highest interest rates, quickly accumulating if not paid off monthly.
  • Consideration: This is the type of debt you should pay off as quickly as possible. The interest rates are far too high to justify holding onto the debt while investing elsewhere.

3. Car Loans

  • Yield Range: 4-10% annually
  • Purpose: Used to finance the purchase of a vehicle.
  • Features:
    • These loans usually come with fixed rates over a term of 3-7 years.
    • Cars depreciate quickly, which makes financing them costly in the long run.
  • Consideration: Depending on the interest rate, paying off a car loan early could save you on interest, but it may not be the best move if your loan rate is low.

4. Student Loans

  • Yield Range: 4-8% annually
  • Purpose: Helps finance higher education.
  • Features:
    • These loans often come with favorable repayment terms, including deferment and income-based repayment options.
  • Consideration: Paying off student loans isn’t urgent if your interest rates are low, especially when other higher-interest debts or better investment opportunities are available.

5. 401(k) Loans

  • Yield Range: Prime rate + 1% to 2% (e.g., if the prime rate is 7.5%, the loan’s interest rate will be 8.5% to 9.5%).
  • Purpose: Allows borrowing against your retirement savings for emergencies or significant expenses.
  • Features:
    • Repayments consist of principal and interest, typically made monthly or bi-weekly via payroll deductions.
    • Interest repaid goes back into your 401(k), effectively “paying yourself.”
    • No credit checks or third-party lender involvement.
  • Consideration:
    • Reduces the growth potential of your retirement savings during the loan period.
    • Leaving your job could require repaying the balance as a lump sum, typically within 60 to 90 days. Failure to do so may result in taxes and penalties.
    • Best used as a last resort to avoid jeopardizing long-term retirement goals.

6. Other Personal Loans

  • Yield Range: 6-15% annually
  • Purpose: Used for a variety of personal expenses, such as medical bills or debt consolidation.
  • Features:
    • These loans tend to have higher interest rates than secured loans like mortgages but lower than credit card debt.
  • Consideration: Paying off high-interest personal loans can be financially wise, but if your rate is closer to the lower end, safe investments may outperform.

Example 1: Should You Pay Off or Invest?

Let’s say you have $50,000 in cash and are trying to decide whether to pay off your mortgage with a 4% interest rate or invest in a low-risk option like U.S. Treasury bonds yielding 4.5%.

  • Paying Off the Mortgage: If you pay off your mortgage, you effectively “earn” a 4% guaranteed return, which is the interest you won’t have to pay.
  • Investing in Treasuries: By investing in Treasury bonds at 4.5%, you’d earn a slightly higher return—$2,250 annually compared to the $2,000 saved by paying off the mortgage.

Conclusion: In this scenario, investing in U.S. Treasuries offers a marginally higher return with the same level of safety. However, the decision may hinge on factors like personal comfort with debt and liquidity needs. If being debt-free provides peace of mind, the difference might not be worth it.

Example 2: Why You Shouldn’t Pay Off a 2.2% Mortgage Early

Now let’s say you’ve got a 30-year fixed mortgage at 2.2%, one of the lowest rates seen in recent years. Should you use extra cash to pay it off early?

  • Paying Off a 2.2% Mortgage: Paying off the mortgage would save you 2.2% annually in interest payments—a low return considering the alternatives.
  • Investing in Ultra-Safe Bonds: With U.S. Treasury bonds or ultra-short-term bond funds currently yielding 4-5%, you could almost double your return by investing the cash instead of paying off your mortgage. These investments are also very low-risk, making them an attractive alternative.

Conclusion: In this case, it doesn’t make much sense to pay off a mortgage with such a low interest rate. By investing in safe options like Treasury bonds, you can achieve a higher return with minimal risk. However, it’s crucial that you don’t use the funds intended to pay off the mortgage for anything other than investing. The funds should remain liquid and accessible in case you need them for your mortgage payments down the road.

Rules of Thumb to Manage Personal Loans

  • Pay Off High-Interest Loans First

    • Example: It’s a no-brainer to first manage your credit card debt that obviously has the highest interest rate! If you have a credit card debt with a 20% APR and a car loan with a 6% interest rate, prioritize paying off the credit card to save on interest costs.

  • Consider Loan Advantages

    • Example: A 401(k) loan allows you to repay yourself with interest, which can be more advantageous than taking out a personal loan with higher interest rates. Similarly, some mortgages or student loans offer tax benefits worth retaining.

  • Refinance to Lower Interest Rates

    • Example 1: Switch your credit card debt to another credit card debt that has lower interest rate or borrow from your 401(k) to pay off the highest interest rate credit card debt if necessary!
    • Example 2: If you’re repaying a 10% personal loan, consider consolidating it into a 6% home equity loan to lower your interest expenses.

Other Key Considerations

  1. Current Loan Interest vs. Investment Return: If your loan’s interest rate is significantly lower than what you can earn with a safe investment, investing the cash is usually the smarter move.

  2. High-Interest Debt: Always pay off high-interest debt first (e.g., credit card debt). The interest rates are far higher than what you could safely earn through investments.

  3. Emergency Fund: Always maintain an emergency fund before paying off debt or investing. This ensures that you have liquidity for unexpected expenses.

  4. Mortgage Payoff Strategy: While paying off a mortgage can be a guaranteed return, low-rate mortgages (like the 2.2% example) shouldn’t be paid off early if you have access to higher-yielding, low-risk investments. But remember, the funds should remain liquid and be used only for their intended purpose.

  5. Personal Peace of Mind: If being debt-free offers you significant emotional relief, it may outweigh the financial benefits of investing, even if the math favors the latter.

By carefully balancing loan interest rates with safe investment opportunities, you can maximize your financial outcomes while maintaining security. Safe investments like U.S. Treasury bonds or ultra-short-term bond funds often provide better returns than low-interest loans, but high-interest debt should always be addressed first.