The Great Debate: Paying Off Loans Vs. Investing During Residency

Whether to pay off loans or invest during residency is a common question among residents. Some residents opt to invest their money in Roth accounts or the stock market, taking advantage of the tax benefits and potential for higher returns. Others choose to focus on aggressively paying off their loans, especially if they have high-interest rates. It's important to consider factors such as interest rates, tax advantages, and personal financial goals when deciding whether to invest or pay off loans during residency.

Paying off a loan early can save you thousands in interest payments

Let's say you borrowed $25,000 for five years at 5% interest. If you pay on time for the full 60 months, you’ll pay $3,307 in interest. Paying it off early can eliminate some of that interest, assuming you are paying simple interest, which most loans are. A simple-interest loan has you pay interest based on what you owe at a given time. The interest on that $25,000 loan would total only $2,635 if you paid it off in four years, a savings of $672.

The faster you can pay off a loan, the less it will cost you in interest. If you can pay off a personal loan early, it can lower your total borrowing costs, potentially saving you a considerable amount of money. For example, let's say you've already repaid $10,000 on a $30,000 personal loan with an interest rate of 10% and three years left on your term. If you paid off the remaining $20,000 balance early in one lump sum, you'd save an estimated $6,000 in interest over the remaining term of the loan.

Mortgages are another example of how paying off a loan early can save you money. Assume that you have a 30-year mortgage with a starting balance of $200,000 and a fixed interest rate of 3.5%. It would work out like this: a larger portion of the fixed monthly payment goes toward paying interest during the first 10 years, but the percentage of the monthly payment that goes toward interest versus principal reverses as time goes on. More than $611 went toward principal while $286.64 went toward interest after 20 years. All but $2.61 of the last monthly payment went toward paying the principal balance.

The total interest cost for the 30-year loan would be $123,312 at the 3.5% interest rate. The borrower would save $20,270 by paying it off 10 years early. Saving more than $20,000 in interest is significant, but the interest amount saved represents only 17% of the total interest cost for a 30-year loan: $103,042 in interest has already been paid in the loan's first 20 years ($123,312 - $20,270), which accounts for 83% of the total interest over the life of the loan.

While paying off a loan early can save you money, there are some cases where it may not be the best option. For example, if you have a precomputed interest loan, the amount of interest you pay is fixed regardless of when you pay it off. Some loans also have prepayment penalties, so be sure to check the details of your loan before making a decision. Additionally, paying off a loan early could potentially impact your credit score, especially if you are still building or repairing your credit.

Investing your money can offer higher returns than paying off a loan

For example, let's say you have a 30-year mortgage of $200,000 with a fixed interest rate of 4.5%. Your monthly payments would be $1,013, and you'd spend a total of $164,813 in interest over the life of the loan. Now, assume that you're able to come up with an extra $300 per month to put toward your mortgage. You'd save $67,816 in interest and pay off your loan 11 years early.

On the other hand, you could take that $300 per month and invest it in an index fund that tracks the S&P 500. Historically, the S&P 500 has returned an average of 10% to 11% annually since its inception in 1926. At the end of 19 years (the time it would take to pay off your mortgage early), you would have $160,780. That's more than double your potential interest savings. In fact, you'd still have about $55,293 left over even if you decided to pay off your mortgage early with your investment funds.

Another benefit of investing is that it gives you more liquidity. Unlike a home, which is an illiquid asset, stocks, bonds, and other market investments can be easily sold and converted to cash if you need to access your money.

Additionally, if you invest your money in a retirement account and your employer offers a match, you get to enjoy compound earnings on that additional free money over time. You'd also be investing pre-tax dollars, which could help you afford larger contributions.

However, investing does come with higher risk. There is more volatility in the stock market than in the housing market, so you need to be sure that your investing timeline is long enough to weather any ups and downs. You also need to make sure that your investment strategy matches your risk tolerance and that you're mentally prepared to take some hits.

Ultimately, the decision to pay off a loan or invest depends on your individual financial situation and goals. It's a good idea to consult a financial professional who can help you weigh the pros and cons of each option and make a decision that's best for you.

Paying off a loan early can give you peace of mind

However, it's important to note that paying off a loan early may not always be the best financial decision. The money spent on paying off your loan early won't be earning compound interest, and the rate at which your money grows in an investment account may be higher than the interest rate on your loan. Additionally, paying off a loan early may result in the loss of some tax breaks, such as the tax deductions for mortgage interest.

Ultimately, the decision to pay off a loan early or invest depends on various factors, including your financial situation, interest rates, and investment options. Consulting a financial advisor can help individuals make informed decisions that align with their goals and risk tolerance.

Investing in a retirement account can give you an employer match

Investing in a retirement account can be a great way to grow your wealth over time, especially if your employer matches your contributions. Compound interest, which is when your interest earns interest, can significantly increase your retirement savings over time. Even if you are just starting out in your career and have a lower salary, it is beneficial to start saving for retirement early. The earlier you start, the more time your money has to grow.

Additionally, if your employer offers a matching contribution, it is like getting free money. For example, if your employer matches your contributions dollar for dollar up to a certain percentage of your salary, you could effectively double your money. This is a great benefit that you should take advantage of if it is offered by your employer.

It is important to note that everyone's financial situation is unique, and there is no one-size-fits-all answer to the question of whether to pay off loans or invest. However, if you are trying to decide between paying off a loan during residency or investing in a retirement account, consider the interest rate on your loan and the potential return on your investments. If the interest rate on your loan is high, it may be more beneficial to pay it off first. On the other hand, if you can earn a higher return by investing, that may be the better option.

It is also worth considering the tax benefits of both options. In some cases, the interest paid on loans may be tax-deductible, which could reduce the overall cost of the loan. Additionally, contributions to certain retirement accounts may be tax-deductible, which could lower your taxable income. Be sure to consult a financial professional to understand the tax implications of your specific situation.

Paying off a loan early can help you build equity

For example, let's say you have a 30-year, $200,000 fixed-rate mortgage with a 4.38% interest rate. By making 13 payments a year instead of 12, you would save $27,216 in interest over the entire term. If you increased your monthly payments by $200, you would save $6,000 in interest over 10 years and $50,745 in interest over 22.5 years, and you would also pay off the mortgage early.

Additionally, paying off a loan early can improve your credit score by lowering your credit utilisation ratio and enhancing your debt-to-income ratio, making you a more attractive candidate for future borrowing. It can also increase your cash flow, allowing you to redirect funds towards other financial goals such as retirement savings or investments.

However, it's important to consider the opportunity cost of paying off a loan early. For example, investing your money instead of using it to pay off a loan may generate higher returns than the interest cost of the loan. Additionally, paying off a loan early may reduce your financial flexibility, as those funds could be allocated to investments or kept as an emergency fund.

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