Low interest rates have raised concerns if it is proper to pay off debt early. The good news is there are ways to determine if you should pay down debt, including the home mortgage, or invest funds to accelerate net worth building. Low interest credit card teaser rates and equity lines of credit add another dimension to the ever evolving world of personal finance. There are two factors to consider when balancing between reducing debt or increasing investments: the return on the investments over the cost of capital and the risk factor.
Personal finance can learn a thing or two from corporate finance when it comes to debt and investment. Just like a business, when a household decides to pay down debt there is a tradeoff. Accelerating debt reduction takes money from other areas, mostly spending or investment, but also reduces risks associated with debt servicing. In this post I will assume you have reduced your spending to a reasonable level and the trade-offs are between debt retirement and investment only.
Think like a Wealthy Accountant
Business owners understand investing capital. To survive, businesses must invest capital to preserve and grow future revenue and profits. Without investment it is only a matter of time before the business stalls followed by decline. At the same time a business invests in its future it also has to keep an eye on debt levels. Many small businesses choose to operate with no debt, funding investment internally; many households do the same. However, a home purchase usually is accompanied by a mortgage. The question now revolves around paying the mortgage off faster or investing the extra funds into investments generating a better return than the mortgage interest rate.
Business schools teach that wealth is created when companies invest capital with a greater return than the cost of capital. This is the right place to start when reviewing personal finances. Low interest rates make it easier to find investments throwing off returns greater than the mortgage interest rate. Currently the S&P 500 yields just over 2%. Alternative investments like Lending Club reasonably return 8-12%. Many corporate bonds throw a higher interest rate than the lowest rate mortgages as long as you are willing to assume risk.
Retirement accounts have significant tax benefits shifting decisions toward investing over debt reduction. For example, if you are in the 25% tax bracket and contribute to a traditional (deductible) retirement account you are guaranteed an upfront 25% advantage from tax savings alone. Any employer matching increases the advantage of investing over addition debt reduction.
It all looks good on paper. Since many investments have a higher return than mortgage debt, it makes sense to be mortgaged to the hilt (leveraged) to maximize wealth building. But that assumes your investments are 100% risk free. Your mortgage is guaranteed to come due or you lose your home and any accumulated equity. Investments do not afford such guarantees. Sure, government bonds and certain bank deposits are guaranteed, but at rates well below the interest rates of any mortgage.
Credit cards now have teaser rates as low as 2%. Clients sometimes want my blessing to borrow from their credit card interest free for a year with a 2% fee, in effect a 2% annual interest rate.* The idea has merit because, once again, it looks good on paper. Unfortunately, the loan comes due in a year regardless and if you don’t pay in full the interest rate goes through the roof. Therefore I never encourage this hyper-risky activity.
Back to the mortgage. People with great credit scores can borrow against their home for around 3%. The broad stock market averages around 7% per year over long periods of time. The current 2% dividend yield is the only real cash flow.** The only way to service debt with money invested in an index fund is from another source. I hate the idea. If the other source dries up you are screwed if the index fund is also down. The dividend yield is not guaranteed, though reasonably stable with an upward bias, is not enough to make full debt service payments. It is safer to not borrow, instead taking the debt service payments you would have made from the other source of income and dollar cost averaging into the index fund over time.
Now for an example of what could work. Alternative investments like Lending Club have significantly higher rates of return on a broad basket of notes owned. A good mix of medium and lower quality notes on the Lending Club or Prosper platforms have high default rates, but with an investment spread among hundreds or thousands of notes the risk is mitigated. I have an account at Prosper and Lending Club. Results have remained steady at around 8% for Prosper and 10-12% for Lending Club.***
Logic would dictate you should max out every lending facility you have and drop it into Lending Club. Except it would be insanity! Yes, I understand Lending Club has better cash flow from loan payments to fund debt servicing without selling notes owned, but there is no guarantee past results will continue. Even wealthy people should only consider micro lending for a small percentage of their portfolio. Borrowing money to invest in a risky business like Lending Club is ill advised. On paper it looks great. However, even a small hiccup could destroy a massive portion of your wealth, even wipe you out. No accountant worth their salt would ever encourage such reckless behavior.
Balancing Act and the Sleep at Night Factor
I will now share how I handle the issue of debt reduction and investing personally. I use several credit cards for a variety of businesses, paying them in full each month.**** The only interest I pay is on my mortgage. I have a farm and farmers get really good deals from the government. My mortgage is from Farm Credit at 2.125 percent. At such a low rate I have struggled with paying the thing off. If, I argue with myself, interest rates ever go up I will have a guaranteed way to make more money than the mortgage interest. It is a big ‘if’. I thought interest rates would be higher by now so my theory was shot down already.
A few years ago my mortgage was around $300,000; it is now under $130,000. I will retire the mortgage in the next 18-24 months regardless what the markets or interest rates do. The mortgage balance was so high a few years back because I used a questionable strategy I alluded to above: I borrowed and invested the money in an index fund. The market treated me well, but there was no guarantee and I took a big (and unwarranted) risk. My income level easily handled the mortgage payment without selling an investment. Currently I max out my retirement accounts and then funnel the remaining free cash flow to mortgage reduction. Small amounts are sometimes diverted to interesting investments, but the goal is now to be 100% debt-free.
There is a “sleep at night” factor involved. How much money is enough? The stunt I pulled was for more money only, a chump’s game. It worked out, but it also could have set me back.
I think eliminating all debt except the mortgage has got to be a top priority in everyone’s life. If you can’t afford an auto without a loan, you can’t afford that auto. Credit card debt is unacceptable ever! Credit cards are a tool to run your business and personal life easier, not a lending tool. Every credit card I have is set to auto-pay the entire balance on the due date. Credit cards have great rewards programs which can benefit users as long as you never carry a balance.
Student loans scare the shit out of me. I never had a student loan in my life and refused to sign one for my daughter going to school. First off, they are hard to discharge if the crap hits the fan in your life. Student loans follow you around like the plague. My opinion is student loans are a priority to eliminate. Self-fund your education instead. The first test of college is getting there. If you don’t have the money, get a scholarship. If you can’t get a scholarship you are not ready for college.
I am more lenient on mortgages. I understand owning a home without a mortgage is difficult in the beginning. However, your loan to value should be reduced to under 50%. That means if you have a $500,000 home, the mortgage should be less than $250,000. At some point you want a plan to retire even this vestige of debt.
A Good Plan
Here is what I consider a good plan balancing debt reduction and investment.
- High interest debt goes first before funding anything else. Credit cards and payday loans fall into this group; student loans and mortgages generally do not.
- If you have bad credit and have a high interest auto loan, sell the auto and find alternative transportation or a vehicle you can afford with cash.
- Now you can fund your retirement accounts. The minimum is the level your employer matches. Once you reach that level it is time to bifurcate your finances between further investments and mortgage debt reduction. If you only have a mortgage or maybe a student loan you can now ramp up investment into your retirement plan. A good goal might include maxing your retirement plans before increasing payments toward debt reduction due to the heavy tax gains retirement plans offer.
- Once the retirement plan is filled each year it is time to set aside money in non-qualified investments (non-retirement accounts) and accelerate mortgage reduction until the mortgage is retired.
The final goal is to be debt-free most of the time. A short-term mortgage to move to a new home might be wiser than selling an investment. Maximizing wealth using leverage is certain to end in tears. It looks good on paper and some accountants even promote the idea of leverage to spur wealth building. The Wealthy Accountant is not one of them. Debt is a useful tool when used sparingly. Most people who are rich have either no debt or modest levels of debt.
I could probably earn more than a 2.125% return on my invested capital; I am still paying off the mortgage. My reason is simple. Without any bills to pay I am free to go and do what I want when I want without worry. And nothing beats a good night of sleep.
* Yes, I understand the annual interest rate is higher than 2% in the example due to payments required during the year. Just play with me. It is an example to highlight how the process works and if it is a viable personal finance choice.
** Don’t even start with me on selling options to generate an income stream. I’ll slap you silly.
*** I started withdrawing funds from Prosper a few years ago. When Lending Club had some legal issues a year ago I started withdrawing funds there, too. New notes purchased tend to spike your rate of return. With both Prosper and Lending Club I noticed a large decline in my return once new investments stopped. For example, Lending Club was always yielding over 12% when I kept reinvesting, but dropped to just over 10% when I started to withdraw funds. The rate is still falling and my guess is it will end around 8%, where Prosper is. Something investors holding Lending Club and similar investments need to consider.
**** I have a post in the queue on how to use credit cards correctly, paying no interest and receiving a large amount of tax-free income. I am waiting for final approval of a credit card aggregator so I can link the credit cards with the greatest tax-free money attached.
I have noticed a trend involving wealth building that is all wrong. I see it in comments on other personal finance blogs a lot lately. I am sure it has been there all the while and it only jumped out at me recently for whatever reason. The misinformation is so important it needs clarification.
The comment goes something like this: I am not saving right now because I am paying off student loans/credit cards/car loans/making extra mortgage payments. When you pay down debt you ARE saving and also building your net worth. The real question is: How can you balance debt reduction with retirement savings for maximum net worth building?
Paying down debt removes the most caustic item on your balance sheet holding back wealth creation. Debt interest is an expense you can only slay by destroying the debt (paying it off). Debt is not a bad thing in and of itself when used as a tool, but most consumer debt is bad. Mortgages are the exception if used properly.
Let’s take some time to explore the best way to reduce debt and maximize return and net worth.
Pecking Order of Debt Reduction
We will address retirement savings in a moment; for now we will focus on debt only. My opinion is built on maximum return for each action you take which is different from other personal finance gurus like Dave Ramsey. Ramsey teaches you should pay the smallest debt balances first (snowball effect) so you reduce the number of bills quickly, giving you a mental boost. I was a Dave Ramsey Endorsed Local Provider (ELP) for years; I am very familiar with his teachings. My advice is slightly different.
I assume we are all adults and understand LESS debt (especially consumer debt) is better. You don’t need hand-holding or mental tricks to act like a responsible adult. You are here because you want to grow your financial understanding and increase your net worth.
The debt with the highest interest rate should be paid down first! Eliminating the highest interest debt does give a psychological boost as interest is reduced at the fastest rate. It also allows for faster net worth accumulation.
Debt payoff IS saving! Think of it this way. Example: You have several loans and a mortgage with payments of $2,000 per month of which $1,600 is interest. Making the minimum payment will increase your net worth $400. Do you get it? You made $2,000 in payments which included $1,600 of interest and $400 loan principle. The $400 reduces your balance, thereby increasing your net worth. Any extra payment will all go to paying down the debt eliminating interest on that part of the liability forever.
Debt Reduction Master Plan
There are a few steps (Ramsey calls them baby steps) to maximize debt reduction.
- Emergency fund: I don’t have an emergency fund. Most people with any amount of net worth generally don’t either. If you are saddled with debt you will need a small emergency fund of $1,000 to $5,000 until you have the resources to handle small emergencies. I don’t want you reducing debt and have a setback that causes more harm than good. A furnace or roof forcing you to take out high interest loans undoes all the hard work you have done reducing debt. Most people can get by with a $1,000 emergency fund. Once you have the financial ability to raise $1,000 or so quickly to handle emergencies the emergency fund is no longer a requirement.
- Order of Debt Reduction: The only way to guide a boat is with a plan. Gather all your bills and debt together and assess the situation. Now you can find ways to reduce spending and funnel the money toward extra payments on debt. Start with the highest interest rate consumer debt and apply the extra payments there. Large balances should be reviewed for refinancing. Eighteen percent credit cards and high interest auto loans and student loans require special attention.
The process is simple in theory, hard in practice. Debt builds easy for too many people. Living within your means and funneling the extra money first to debt reduction and later to investments is a radical shift requiring new habits. Cut spending to the bone. Every extra dollar reduces debt faster.
Track your debt reduction on a spreadsheet. Each month you should see the interest expense declining. From our example above, if your interest is $1,600 this month, the $400 principle payment and any additional payment applied to the balance will reduce the interest expense going forward. Next month your interest will be less, let’s say $1,580. Now you reduce your debt this month $420 just with the minimum payment. Staying on course does not mean paying small credit card balances first to get a psychological boost. The mental boost comes from seeing the interest assessed each month drop like a rock.
Debt is a crisis as serious as a heart attack. The trick is to eliminate debt as fast as possible without making the problem worse. The balancing act comes from taxes and retirement plans.
I know the desire is to fund a 401(k) up to the matching level regardless your debt level. I feel the same, but also know if your debt is high, funding anything other than debt reduction risks toppling the house of cards. When debt is maxed out you need to regain control of your finances first to bring you back from the edge. Once you have a small emergency fund and the most egregious debt well on its way to debt Hades you can consider balancing debt reduction with investing.
Just like paying off the highest interest rate debt first is a priority, you now need to bring investment returns into the equation. In this instance we only consider guaranteed rates of return. The stock market has excellent long-term returns, but they are not guaranteed. Employer retirement plan matching is one area of guaranteed high return. Investing into your employer’s retirement plan to the matching level provides two benefits: a high instant return on your investment (100% if funds are matched dollar for dollar) and a tax break. (In this post I will assume retirement investments are the deductible kind. The discussion between traditional and Roth retirement plans are left for another day.)
In the United States the tax code is stacked against spenders. The government taxes the shit out of you when you spend (income tax, sales tax, excise tax, gas tax, et cetera). What Congress has a hard time doing is taxing savers. To appease the masses Congress created several tax advantages for savers. The cost is minimal to government collections because most people are stupid and spend all their money and then borrow some more. You are not one of those people.
Savers pay a significantly reduced tax bill. We will focus on two benefits today: the Savers Credit and deductions. The Savers Credit applies to the first $2,000 net investment to retirement plans. Distributions from retirement plans affect the Savers Credit negatively so leave your fingers off the retirement stash. The Savers Credit is up to $1,000 per year. You never pay it back. The extra tax savings can be used to increase retirement investments. Unfortunately the Savers Credit is limited to relatively low income taxpayers. For example, the credit for joint filers phases out at $61,000. The Savers Credit is generally smaller for most people, around $200. Still, $200 is a nice additional benefit for investing in your future.
Traditional retirement plans (IRAs, 401(k), and similar employer plans) are tax deferred. Your contributions to the plan are not included in income until distribution. If your tax bracket is 25% and your employer matches dollar for dollar, your first year return prior to any investment gain is 125%. (I am aware I am playing fast and loose with the math. The goal is to show the return is large.) While you are in debt reduction mode you still want to take advantage of such generous opportunities whenever possible.
Putting It All Together
Let’s take a look at what we learned and put it into order for easier use:
- Assess Your Situation: Create an honest personal balance sheet, including all assets and debts. Now you have your net worth and all debts owed on one understandable page. Next, create an income statement from the household income and expenses. The income statement should help in determining where expenses can be reduced and applied to debt reduction.
- Assess the Debt: Debt should have a separate page to assess debt balances and a payoff strategy. List the debt with the balance and interest rate. Start with the highest interest rate debt and apply additional payments to this liability until it is laid to rest. Then move on to the next victim.
- Emergency Fund: Build a small emergency fund if your debt situation is excessive. You don’t want a flat tire to sink you right back into high interest debt.
- Prioritize Debt Reduction and Retirement Planning: Once you are away from the precipice it is time to maximize net worth building. Employer retirement plans with matching will provide a greater return on investment than the interest you are paying in most cases. Participating in an employer’s retirement plan to the matching level is an intelligent financial move. Don’t lose sight of debt reduction. The goal is to reach the highest net worth without risk. Debt reduction is a guaranteed return. Debt paid off does not accrue additional interest expenses. Once debt is eliminated you will max out all retirement accounts for the largest tax savings.
- Good Debt, Bad Debt: In my opinion consumer debt is bad. Car loans and credit card balances are caustic to financial health. (We leave credit card bonuses for another post.) Mortgages are different. We never get a loan because the interest is deductible, ever! Mortgages, however, are generally lower interest loans and will be one of the last things you pay off. Mortgages can be a powerful financial planning tool when used correctly.
- Mortgages: When consumer loans (auto, credit cards, et cetera) are eliminated it is now time to plan the assassination of the mortgage. I have a small mortgage and plan on killing it over the next two years even though it is not a net worth maximizing strategy. I started with a $300,000 death pledge and decided to plan its murder. I chopped it to under $130,000 this year with the final assault killing the darn thing over the next year or two. It hurts when I do this. The interest rate on my mortgage is 2.375%. Any other investment would have a better return than the mortgage cost. However, there is something to be said about living debt-free. Once your net worth is well on its way it is not always about maximizing the results. Debt spikes returns when things are increasing in price, but also causes downward spikes when things are not all roses. Debt-free is good even when it is not the best financial move. It is the best ‘sleep at night’ move.
- Time for Rocket Man: Once debt is history in your life you will have massive amounts of money to invest in retirement plans and index funds. Your skills acquired while reducing debt are still in play. While you reduced debt you learned how to cut costs, increase income, live within your means, and still remain happy with life. Without debt it takes almost nothing to live. Debt is what makes it so hard to make ends meet; the ends are rather close without debt payments. Now, interest is turned on its head. Instead of paying interest you are earning a return on your investments. What a concept!
There is no better feeling than waking in the morning, taking a deep sniff, and knowing you already made $722, more than you will spend in a week. A modest nest egg with no debt will generate a nice income stream to cover your lifestyle. Interest income, dividends, rents, and business profits all add to the mix. Like I said, the plan is simple in theory, difficult in practice. The sooner you start, the sooner you reach your goal, regain your sanity, and start living life the way you were meant to.