One of the most common financial decisions is whether to use available money to repay debt or invest it to obtain a return. There is no single answer: the best option depends on the type of debt, the interest rate and your financial goals. In this article, we analyse the key factors to help you make the decision.
The first thing to bear in mind is that not all debts are the same, and not all have the same impact on your financial situation. It may seem obvious, but we are not talking about the same debt when we refer to a mortgage as when we refer to a consumer loan. The difference is not only in the purpose, but also in the interest rate and the value that each one provides.
It is also important to take into account our stage of life. For example, it is reasonable to take on debt when you are young to buy the house that will become your main residence, or to start a business. In both cases, it is something that can increase our wealth or even generate income for us. On the other hand, it is not advisable to take out a loan to buy a new TV or even to go into debt to buy a car, as these usually have high interest rates and do not generate long-term value.
How much can I borrow?
Before deciding whether to repay debt or invest, it is essential to understand whether your level of debt is healthy. A preliminary consideration before all of the above is our level of indebtedness. Percentages vary depending on the experts, but there is some consensus that debts that significantly exceed 30% of our income can make life difficult. The 28/36 rule, for example, establishes that housing-related expenses — including the mortgage — should not exceed 28% of our income. If we include consumer loans and debts such as car financing, the maximum is 36%.
Another general recommendation is to avoid short-term debt, especially debt with high interest rates. Financial disasters often begin innocently, with small loans or credit card instalments. Even if the amount is not very large, this type of debt usually has high interest rates that can quickly become a major problem. That is why it is advisable to pay off these debts as soon as possible.
A clear example is revolving credit cards. These cards allow the credit spent to be repaid through monthly instalments chosen by the cardholder, with associated interest, of course. They can be a useful financing tool because of their flexibility, but danger is always lurking behind them. A combination of high interest and low instalments can be lethal: as financial analyst Natalia de Santiago explains, if the instalment we choose does not cover the interest, the debt, far from decreasing with each payment, increases. And thanks to compound interest, it can quickly become a very serious problem for our balance sheet.
Repay debt or invest
If we do not have short-term debt and our level of indebtedness is under control, we can examine more calmly what to do with our money. The question arises when we accumulate a certain amount or it “falls from the sky” through a prize or inheritance: what should we do, repay debt or invest? The most common situation is that the debt is a mortgage.
To better understand the differences, this comparison summarises the main factors:
| Repay debt | Invest | |
|---|---|---|
| Objective | Reduce interest and term/instalment | Seek capital growth |
| Risk | Low (“guaranteed” return = interest saved) | Medium/high (return not guaranteed) |
| Liquidity | Low money “trapped” in the debt | Medium/high depending on the asset |
| Horizon | Short/medium term immediate impact on interest | Medium/long term benefit from compound interest |
| Psychology | Less financial stress | Greater volatility in exchange for potential |
| When to prioritise | Expensive debt or early years of the mortgage | Low rate, emergency fund in place and long horizon |
What should you take into account?
One of the key factors is the interest rate of the debt: the longer the term, the more interest we will pay. It follows that, if we repay the mortgage early and reduce the term, we can save money on interest. You should always keep in mind the fees for partial and full early repayment of your mortgage, as they are another cost of the transaction. In simple terms: if the interest you pay on your debt is higher than the return you expect to obtain by investing, it is usually more efficient to repay. If the opposite is true, investing may make more sense.
In Spain, due to the French amortisation system, much more interest is paid at the beginning of the loan than at the end. That is why reducing the term makes more sense if we are in the early years of the mortgage than if we are approaching maturity. However, if the interest rate we pay is low, it may make more sense to invest the money instead of repaying the mortgage early.
To know this, we would need to use the amortisation schedule and see how much interest we could save by reducing the term, and compare that amount with what we could foreseeably obtain if we invested the money instead of repaying the mortgage early.
Let’s look at a simplified example: imagine you have a mortgage of 200,000 euros over 30 years, at a fixed rate of 3%. If you pay the minimum monthly instalment of 843 euros, over the life of the mortgage you will pay 103,555 euros in interest. If you paid 266 euros more each month, you would finish paying off the mortgage in 20 years, saving 37,347 euros. However, if you had invested those 266 euros instead of putting them towards the mortgage in something with an annual return of 4%, over 20 years you would have obtained 97,562 euros, that is, 60,215 euros more than what you would have saved in mortgage interest…
In general, repaying debt is usually the best option when the interest rate is high or when it is short-term debt. By contrast, investing may make more sense when the cost of debt is low and the time horizon is long, as it allows you to benefit from capital growth.
In any case, the decision is not universal: it depends on your financial situation, your risk tolerance and your long-term goals.
Imagine you have a mortgage of 200,000 euros over 30 years, at a fixed rate of 3%. If you pay the minimum monthly instalment of 843 euros, over the life of the mortgage you will pay 103,555 euros in interest. If you paid 266 euros more each month, you would finish paying off the mortgage in 20 years, saving 37,347 euros. However, if you had invested those 266 euros instead of putting them towards the mortgage in something with an annual return of 4%, over 20 years you would have obtained 97,562 euros, that is, 60,215 euros more than what you would have saved in mortgage interest…
We hope we have helped you decide whether to repay debt or invest. If you choose to invest, at Urbanitae we help you choose the right assets and diversify. There are alternatives within the real estate sector that allow you to access this market with different levels of risk and time horizons.
