Explain to me how paying 5% loan is same as 5% return on investment

Investing Forum
1

Long story short, my friend and I are having a debate. His financial advisor says, ‘if investment returns are equal to debt interest, investing wins because it is compounding interest, and paying down debt is just simple interest.’

I once went through the math and came to the conclusion that paying down a 5% interest loan with extra payments is the exact same return as investing the same amount per month on an investment that returns 5%.

He’s convinced that paying down loans with extra payments is less valuable because it involves ‘simple interest, not compound.’ Any good way to explain how they’re the same?

Obviously, a financial advisor would rather keep debt and invest money under AUM if it’s a tie-breaker. I also know that paying down low-interest debt is not wise long-term compared to investing. I’m just picking 5% as a round number for both to be set at.

2

Congrats, you have proof his financial advisor is bad!

Debts and investments both compound. In fact, investment income is taxable, so if you make 5% on your investment, it’s potentially worse than paying 5% on your debt.

3

@Rachel
Even in that situation, paying down debt is better because your liability is lowered. Hedging debt only works for people when there’s a significant difference in interest rates or a large amount of money; otherwise, it’s a headache for small gains.

4

5% simple interest is less than 5% compound interest.

Accumulating $1 over 5 years with simple interest:
1*(1 + .05*5) = 1.25

With compound interest:
1*(1 + .05)^5 = 1.28

But the advisor is still wrong because most debt is not simple interest; it’s compound.

5

The financial advisor is lying. Both investment returns and debts are compounding. It’s a fact!

Also, investments increase your future tax burden, while paying down debt does not. So, all else (including rate) being equal, paying down debt is better.

6

Paying extra toward the principal compounds the interest savings because less interest accrues. With every payment, less money goes to interest, and more goes to the principal, accelerating the debt repayment. This creates a compounding effect on interest savings.

7

@Malik
Thank you! This is what I was looking for!

8

Your friend is wrong. Most debts are compound interest as well.

Also, your investment profits are taxable, so your real return is less than 5%. If your tax rate is 20%, that reduces your investment return to 4%. Debt payments aren’t taxed, so paying a 5% debt is often better than investing at 5%.

9

The financial advisor is wrong. Let’s say you have $1,000, which you could invest at 10% or use to pay off a $1,000 loan with 10% interest.

If you invest, after 5 years it’s worth $1,610, but you’ve paid $500 in loan interest. Net profit is $110.

If you pay off the loan, the $100 saved each year gets invested at 10%, and your total is also $110. In both cases, the compounding effect is present.

10

@Lilnim
Well stated. I’ll probably send this exact scenario to him.