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.
Sunday 15th of July 2018
Is there ever a situation where you would recommend that someone pay down the mortgage before they maxed out their tax advantaged accounts?
Sunday 15th of July 2018
I'm sure there is, Chris, but none come to mind. Facts and circumstances always rule. Personal preference is a good enough reason for me since paying down the mortgage creates a guaranteed return in the form of less interest paid. Health care issues play such a huge role in the U.S. nowadays that I can foresee situations where the regular rules are turned upside down to maximize financial benefits. Most debt needs to go. If the property is over-leveraged I would want to pay the mortgage down a bit faster at the expense of funding 401(k)s, et cetera. The higher the mortgage interest rate the faster I want to knock it down also.