While many people are actually “scared” of debt, there are occasions when a manageable debt load can actually be very beneficial to you in the longer term.  During the last Bull run in the US stock market there were many investors who had substantial (although manageable) mortgages to pay off, but also had excess capital which they invested into the stock market.  So when does it actually make sense to retain debt and try to make excess capital work for you?

While many people would choose the obvious route of paying off their mortgage (or other debt) if they came into some money, thereby reducing their interest payments and actually owning their home much earlier than expected, this is not always the “best” choice.  However, before even considering investing your money rather than paying off a debt, you need to clarify the risk / reward ratio of your potential investment against the savings which you would make by paying of your debt early.  Let us take two examples :-

Example One

You have a mortgage of $100,000 outstanding which is due for payment in full in 3 years.  The interest rate on the mortgage is only 3% per annum.  You can easily afford the regular payments required over the next 3 years.

You then receive a payout of $100,000 which you consider using to pay off your mortgage to free you of debt.  However, you are looking at the stock market and possibly investing your windfall rather than paying off your mortgage in full.  Analysts are very keen on the state of the US economy and the business world, with many forecasting increases in the market of at least 10% per annum for the next three years.

What would you do?

While the initial pull would be towards paying off your mortgage and becoming debt free, this may not be the correct move when you consider you are paying 3% interest on your mortgage, but an investment in the stock market may yield you in excess of 10% a year capital growth each year for the next three years.  By investing into the stock market you could not only clear an extra 7% per year (the difference between your mortgage rate and potential investment return), but the “interest” earned would also increase in year two and year three, etc – thereby compounding the rate of return to in excess of 10% - if all goes well.

In this situation the difference between the expected rate of return from the stock market and the rate you pay on your mortgage is fairly large, and probably worth the risk, all things being equal.

Example Two

The mortgage situation is the same, $100,000 outstanding which is due for payment in full in 3 years but the interest rate is 5%.

You receive your $100,000 windfall and someone offers you a very high risk investment which has the potential to double over three years.  Surely that must be something worth considering?

This is a situation where the risk / reward ratio is out of synch in that you are only being offered the potential high return because there is a greater degree of risk.  How many risk free investment do you know which could double over three years? 

What happens if the investment fails and you lose all of your money, you would be $100,000 down and still have a mortgage outstanding.

Conclusion

While the above examples may seem a little extreme they are a lot more common than you might think.  As well as considering the risk reward ratio it is vital that you also consider what may happen to interest rates over the period, is your mortgage fixed, do you have any large payments to make in the short term, do you have any funds to be paid to you in the short term, etc.  These are just a few elements which you need to take into consideration before making your decision.

However, it has to be said that nothing is ever guaranteed and in the example of the stock market we may see an unexpected crash, or investments may not reach the heady heights of the 10% return a year forecast.  At any one time the only thing definite is the fact that you have a mortgage outstanding on which you are being charged a rate of x%.  The rest as they say is a gamble, but one which can pay off handsomely if you do your homework!