Question

Assume you have recently graduated with your business degree, and landed a new position at a company you had been researching during your senior year in college. You have been offered a lump-sum, sign-on bonus of $5,000. You also recently purchased a new condominium and vehicle. These items, in addition to your student loans, comprise your personal debt. Consider your debt reduction and investment earnings potential, as well as any applicable taxes. Assume that tax rates are stable over the next 10 years, and inflation is low (<1% per year) and does not change. Would you personally choose to invest the $5,000 sign-on bonus, or use it to pay down your debt? Regardless of your decision to either invest or pay down debt, be specific regarding the type of investment or debt payment you would make. Provide specific rationale for your decision. You may develop a quantitative example to support your rationale.

Answer 1

We need to understand few things before arriving at the final decision.

Advantage of using the signing bonus to pay off my debts:- It will reduce my interest outgo in future. For example, if my debt is exactly $5,000 and my interest rate is 4%, I will end up paying up the interest of $200 in the first year.The interest paid is basically the cost of taking loan. If you take loan of $5,000 let's say for 5 years, you will probably end up paying $6,200 in the entire duration. So in this case, $700 that you will pay extra to the bank can be saved if you choose to pay off the entire debt in one go

Advantage of using the signing bonus to invest: If you invest the money in market, it will grow. $5,000 invested at let's say 4% for 5 years will become $6,083 at the end of 5 years, compounded annually.

The ultimate decision boils down to this- What is higher? The cost of debt OR the rate of investment?

If I pay interest rate of 4% and I expect that market (like Mutual Funds) will give me return of 5% in near future, I will choose to invest rather than paying off my debt. However, if the numbers are exchanged, it is advisable to invest.

Currently, student education loans in USA are typically in range of 4%. The T bill returns have fallen in recent times, and are close to 2%. So if I assume that my money will grow at let's say 3% if invested only in money market funds, it will not be prudent to invest. I will use my bonus to pay off my debt in single shot pre-payment.

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