Debt is often tagged as evil in the personal finance community. It makes sense as many dig themselves into a hole by accumulating a mountain of debt. The average class of 2016 college graduates left school with $37,000 in student loans. The average credit card debt for those that carry a balance is around $16,000. With the ever-rising cost of a college education and companies spending billions of dollars to convince us to buy their crap, it’s no wonder that debt is a hot topic.
Paying 18% interest on $16,000 in debt is a deep hole to climb out of, graduating with nearly as much in student loan debt as your first-year salary puts a hamper on building wealth. I do understand the mindset for people who want to get out of their student loans and credit card debt at all costs.
But not all debt is something to be feared or shunned. Debt can serve as an excellent tool when used effectively and responsibly. Liability can be an excellent tool for growing your wealth. Without the ability to take out a mortgage, you would be stuck paying rent to someone for years. Money that betters someone else by growing their passive income, but is forever lost to you. Without the ability to take out student loans, many would have a hard time paying for the increasing cost of a college education.
Maximize the Utility of Your Dollars
Paying down debt is not a bad thing in and of itself. At the very least, you are locking in a return equal to the interest rate on your mortgage. If your student loan debt carries an interest rate of 6%, you earn a guaranteed 6% return on any extra money you throw towards paying down the principal. That’s an excellent conservative return on your money. But at what tradeoff? Could you have invested your cash differently for a higher return? The S&P 500 has historically returned 10% with dividends. Over the past ten year period, while suffering through the worst financial crisis since the Great Depression, the market still returned 7%.
Perhaps you’re willing to trade off a few percents in excess returns for a safe return of 6%. But the decision gets more robust when it comes to lower interest rate debt that has become commonplace over the last decade. If you locked in a 15-year mortgage previous summer, you likely received a rate under 3%. Considering the tax savings derived from deducting your mortgage interest, the effective rate is closer to 2.5%. Even if you have a higher rate of say 3.5%, your effective price after-tax savings are closer to 3%. Does a 3% return fit in with your investment plan? Perhaps it does, if you’re seeking to maintain the wealth, you’ve already built. But if you’re like me and still in the wealth accumulation phase, then you’re likely seeking a higher return on your money.
The Power of Compounding
Let’s use my current situation as an example. I have ten years left on my mortgage with a balance of about $100,000, carrying an interest rate of 3.5%. Ten years is a long time, and it would be nice to see that mortgage wiped clean. But would that make sense? What would be the tradeoff from a dollar standpoint?
This past year I paid about $3,750 in mortgage interest. Because I itemize deductions, I will receive a tax benefit of about $750 (3,750 x 20% effective tax rate). So on a net basis, my mortgage cost me $3,000 in 2016. Not a lot of money, but money coming out of my pocket nonetheless.
Here’s what the remaining ten years on my mortgage will cost me if I don’t allocate any additional payments to the principal.
Cost of Remaining Mortgage
So over ten years, I’ll pay just over $19,000 in interest but receive tax benefits of nearly $4,000. In the end, it will cost me about $15,500 in importance to the bank to be free and clear of my mortgage.
My current cash flow would allow me to lob an extra $2,000 each month towards mortgage principal. Doing this would wipe out my mortgage in 3 years. No longer having to make a mortgage payment each month is enticing. But is that a wise investment for my money? The alternative is investing the $2,000 in the stock market each month.
So I have two options. First, I can pay off the mortgage over three years and then invest the $2,000 along with the current P&I payments of $1,000 into the market beginning in year 4. Or there’s option 2. Pay the mortgage as initially agreed over ten years and invest $2,000 monthly in stocks.
Let’s have a look at Option 1. We’ll need to calculate the growth of investing $3,000 monthly in the stock market for over seven years. Then we’ll net against that the cost of the mortgage interest after paying off the mortgage in 3 years.
Option 1: Payoff Mortgage Then Invest
By paying off my mortgage early, I would save nearly $11,000 after accounting for tax benefits. After the mortgage is paid off in 3 years, I could begin allocating the $2,000 additional monthly payment along with the $1,000 P&I mortgage payment towards investments. Investing $3,000 monthly over seven years would give me a portfolio of about $339,000. Netting this with the mortgage interest over three years works out to $334,000.
Now let’s see what happens when I made the mortgage ride for ten years, and invest today. In this case, I only have $2,000 to spend each month as $1,000 will be going towards P&I on the mortgage for the next ten years. But, I will be able to start investing three years earlier than Option 1.
Option 2: Invest Now
Investing $2k monthly starting today gives me a portfolio of $368,000 after ten years. This netted with the net cost of the mortgage over ten years gives me a total value of nearly $353,000. So while the mortgage will end up costing me $11,000 more, my investment balance will grow higher by $30,000. Therefore, Option 2 nets me $19,000 additional over 10 years.
This isn’t a huge difference, but one significant benefit I see is increased liquidity. At the end of 3 years, I’ll have over $80,000 in the investment account. This provides a lot of cash to cover significant unexpected expenses. Furthermore, the additional three years of investing are the time I will never get back. Time is the biggest asset when it comes to growing wealth, and it’s essential not to waste it. While the difference is only $19,000 after ten years, when we compound for another 15 years to age 60, the gap grows to $87,000 — a lot of money to give up to get rid of that pesky debt.
Consider Investment Goals
We discussed this earlier, but one important consideration that isn’t often mentioned in the debt payoff discussion is what your investment goals are? Perhaps you’ve already built a great deal of wealth. Your goals are geared more towards preserving wealth than growing it. Therefore you look for safer investments. Earning a guaranteed 3% return is pretty good for a safe investment these days.
But what if you’re still in the wealth accumulation phase? This description currently fits me as I continue my path towards FIRE. As I’m still young and have a long investing timeline, I’m willing to take on more risk for higher returns. Therefore, a 3% return doesn’t interest me. My money goes into stocks and other higher-yield investments. While these investments carry more volatility, they also provide higher returns over the long run.
The Debt Payoff Guide
There’s a lot to consider when deciding to pay down debt or invest. A lot of different factors go into making the decision. The two most important factors being the interest rate on your mortgage and your investment strategy. The following given table can be used as a guide when making this decision.
A couple of critical considerations to point out. When the debt interest rate starts to approach 7%, the chances of coming out even with the market increase. But the benefit of choosing to invest over paying down debt is the increased liquidity you get. Therefore, if you’re in the growth stage of accumulating wealth, I recommend investing up to the point of 7% interest rate.
A similar point can be made for the conservative investor with rates of up to 3%. A conservative investor is less concerned with growing wealth and more concerned with preserving it. Therefore, they would likely welcome a 3% return on a portion of their portfolio. However, I would be more inclined to invest in a safe asset earning 3% than paying down debt at 3% for liquidity purposes. Another strategy would be to invest in dividend-paying stocks instead of paying down debt. Investing solely in Dividend Champions (companies increasing dividends for 25+ straight years) could easily score you a yield of 3-3.5%. This would permanently fund your debt for free.
Readers, what do you consider when deciding to invest or pay down debt? Share your own experiences in the comments below. If you’ve made these decisions in the past, would you do anything differently today?