Debt Paydown vs. Investing
Some folks who have a mortgage, student loans and/or car loans are in the enviable position to consider paying down or paying off that debt from their cash or investment accounts. If a person I’m meeting with has that option, then here’s how I approach the issue:
Financing a big purchase isn’t a bad thing, despite the stories of family members from the past who “only paid cash for everything.” For our purposes, let’s assume a client named John asks for my advice on his $50,000 mortgage balance with 8 years of payments remaining. He has $75,000 in a bank or investment account and wonders whether he should just pay off the mortgage and be done with it. Three factors need to be considered:
1. Emergency Money. If John pays off the mortgage, will he still have sufficient funds for an emergency? Everyone should always have easy access to cash that will cover 6-12 months of recurring expenses. Paying off debt is not recommended if it minimizes or eliminates your emergency fund.
2. Rate Comparison. If the emergency fund is covered, then the next question I ask is the rate of interest John is paying on the debt (in this example, a mortgage). If it is equal to or greater than 6%, then I recommend he seriously consider paying down the debt as quickly as possible while still having an ample emergency fund. Why 6%? Because if your debt interest rate is less than 6%, and you are willing to invest your money appropriately, then you will likely get more bang for your buck by investing and paying the debt in installments.
Here’s an example: Let’ say John’s mortgage interest rate in the above example is 4%. Let’s further assume John’s investments are in a diversified low-cost index portfolio with an average annual return of 5.75% – a very reasonable assumption. While invested for the year, the $50,000 John is considering paying off the mortgage with is making $2,875 (5.75% of $50,000). At 4% interest, John’s annual interest payment on his mortgage is $2,000 (4% of $50,000). By keeping the mortgage and investing the balance, he can make $2,875 and owe $2,000 for a net gain of $875. If he cashes in the investment and pays off the mortgage, he is saving $2,000 in mortgage payments but losing out on the $2,875 gain on his investments. The net loss is $875.
Realistic returns on a well-diversified and moderately aggressive investment portfolio are around 7%-10%, but they don’t produce that every year, so I err on the conservative side by using the 6% rule in debt repayment analysis. If John was a more aggressive investor, he may consider keeping debt with an interest rate of 7%; or only 5% if he is a very conservative investor.
If John’s money isn’t really working for him because it is just sitting in a checking account making 1%-2%, then his money can work much harder for him by paying off that 4% mortgage. But before I would tell John to take that cash from the bank account to pay off the mortgage, I would gauge his comfort in investing it. If he can’t stomach the market volatility, then debt repayment makes better sense than a low interest checking account. If he can take the volatility, then I usually recommend he keep paying on the mortgage and invest the money.
3. Peace of Mind. Finally, John can’t forget the intangible component that is peace of mind. How you sleep at night should always be a factor in your financial decisions because your money is there to make you feel protected. If paying off the mortgage just makes John feel better and he doesn’t want his loved ones to worry about the debt if he dies unexpectedly, then debt repayment makes sense despite the numbers we looked at above. This same analysis applies to any debt – student loans, car loans and the like.
As you can see, there is no absolute objective answer to the debt vs. investing question. But there is a methodology that can certainly help you make an informed decision. Feel free to call my office if you have any questions because every situation is unique.
Personally, I paid off my mortgage sooner than I needed to because I wanted the peace of mind. However, I financed my last car that I could have paid cash for because the dealership offered a 60-month 3.9% rate. I jumped at that rate because I’m confident I can make my money work harder through my investment portfolio.
Fun Fact: For those of you old enough to remember, CD rates in the 1970s were almost unfathomable today. In 1979 the average 3-month CD rate was 11.2%, but before you long for those days gone by, remember that inflation in 1979 was at 11.3%, so that CD was really producing a net loss in purchasing power of .1% annually. Today 3-month CD rates are closer to 4%, and with inflation currently around 2.67%, your current CD is gaining purchasing power each year despite the much lower rate. The “good old days” weren’t necessarily that good on the CD front.
