Time for another round of Answer the Reader’s Mail: Repay Debt or Invest?
Today’s letter comes from Chris, a 25-year-old who — based on his profile photo — I assume is also a newlywed. (Congrats!) Chris asks:
“Invest for retirement or pay down debt? This may be more of a personal choice than anything, but I have been subscribed to the ‘pay down your debt before you invest’ camp for about a year now.
I should have my debt paid off by mid-2012 if I stick to that plan, but am I going to regret my year and a half hiatus from retirement contribution? I’m only 25 with many years of compounding interest to look forward to.”
“Repay debt or invest?” is a classic question; as timeless as “chicken or egg?” and “chocolate or vanilla?”
For those of you who haven’t heard this question before, here’s the background:
One school of thought says repaying your debt should always be your top priority, no matter what. Debt psychologically traps you, and it guarantees that you’ll lose money to interest payments every month.
But another school of thought believes that – in certain, limited cases – you can earn bigger returns if you invest your money rather than use it to repay your debt. If you can earn 6 percent through your investments, and your interest rate is only 4 percent, then you’re “losing” 2 percent — in opportunity cost — by repaying your debt rather than investing.
At the core, the two camps are having a classic argument between risk and reward. The anti-debt camp focuses on your risk – the guaranteed loss of interest. The pro-invest camp focuses on the potential reward – the opportunity to multiply your gains.
(Check out this post — especially the bottom half — for a detailed explanation of the “borrow money to invest” argument.)
Both crowds agree that if you have credit card debt with a 20 percent interest rate, you should pay it off immediately. But the two crowds have different reasons for thinking this.
The anti-debt crowd says you should repay your credit cards so you can stop losing money on interest. The pro-invest crowd believes you should repay that debt because you won’t find a reasonable investment that pays more than 20 percent.
Repay Debt or Invest: Which Crowd Is Right?
Neither crowd is “right” or “wrong.” Personal finance is 99 percent psychology and emotion, so you need to decide what will help you sleep easiest at night.
But here are a few things to consider.
#1: Retirement Match
Does your boss offer a retirement match? If so, that’s a guaranteed 50 percent (or more) “return” on each dollar that you contribute. You can’t beat that rate, ever.
If your job offers a retirement contribution match, squeeze it for every penny you can get. Otherwise you’re passing up a chance to “earn” 50 cents (or more) on every dollar.
#2: Tax Benefits
I’m the last person on earth who will advise you to do something FOR the tax benefit. Do something only if it’s a good idea. The tax benefit should just be the icing on the cake.
That said, if you’re young and in a low tax bracket, investing in a Roth IRA could be a huge win. You’ll pay taxes on that income now – at your current low tax rate – and never pay a dime in taxes again, not even on your dividends and capital gains. That’s huge.
If the interest rate on your debt is low enough, you might want to jump at the chance to waive dividend/capital gains taxes for the rest of your life.
#3: Your Interest Rate
This is the obvious question. The higher the interest rate on your debt, the harder it is to justify putting off the payment.
But how high is too high?
Warren Buffet predicts that the U.S. stock market, over the long haul, will return roughly 7 percent a year. It’s important to remember that he’s talking about a long-term average – a 15-to-20 year “big picture” window. In the short term (1 – 5 years), the market could grow more slowly, or it could collapse like it did in 2008-09.
But I’m not a fan of gambling on what you hope the market might do. So let’s look at another metric.
#4: Dividend Payouts
A safer way to invest would be to look at the return you can earn from dividend payouts offered by a stock.
Here’s how you calculate this:
One share from the McDonalds Corporation trades at $98. McDonalds offers a dividend payment of 70 cents per quarter, or $2.80 per year.
Basically, this means that for you’ll get $2.80 per year for each share of McDonalds stock you own – regardless of whether the stock price goes up or down.
What kind of return is that?
Take the yearly dividend payment = $2.80. Divide it by the price at which YOU buy the stock = $98. Multiply the result by 100.
(2.8/98)*100 = 2.85 percent. You’ll earn a 2.8 percent return from the dividend on this stock.
Back in January 2011, McDonalds was trading at $74 per share. If you had bought shares at that time, your dividend return would be 3.7 percent. (2.8/74)*100 = 3.78. The fact that the stock ALSO grew by $24 a share is just icing on the cake.
That’s why an essential truth about investing is that you make money when you buy, not when you sell.
As a general rule of thumb, I’d assume you could collect about 3.5 percent, on average, in dividend returns, if you target your money toward high-dividend stocks. If you’re really good, you might be able to collect 4 percent.
Don’t wade into this field unless you’re psychologically prepared to handle the inevitable ups and downs in the value of the underlying stock.
(Side note: The best way to handle this is just to ignore it. Remember, stock price is purely theoretical unless you’re buying or selling.)
#5: Rental Properties
I can’t say enough good things about these. If you can buy a property with a positive cash flow, do it. This is a perfect example of the positive power of debt.
For a conceptual overview, check out this post, and to hear the story of how I did it, check out this series.
#6: Launching Your Own Business
On one hand, small business loans are tough to get, and the interest rates are higher than, say, the rates on a student loan.
On the other hand, small business is incredibly risky. It might be the next Subway / Facebook / Pepsi, or it might fall flat on its face.
In my family’s business, we’ve avoided taking business loans unless we need “upfront” capital to fund a project we’ve been awarded. In other words, we avoid loans unless we have I.O.U.’s to match.
#7: Inflation
Everyone seems to forget this critical piece of the puzzle. If you hold debt, inflation is your best friend.
Why? Here’s how it works: Right now the mortgage on my investment property (paid through rent from my tenants) is $1,200 per month. This is a fixed-rate payment; it will never change.
In the year 2012, that amount – $1,200 – has a certain amount of purchasing power. It can buy a round-trip ticket from New York to Cape Town, South Africa. It can buy 1/3rd of a Louis Vuitton handbag. It can buy six Kindle Fires.
But 30 years from now, in 2041, that same $1,200 will probably buy me a loaf of bread. (I’m exaggerating, but you get my point.) Inflation will have eroded its purchasing power.
In other words, with each passing year, I repay my mortgage with “cheaper” dollars.
Inflation tends to average about 3 percent per year. If the interest on your debt is low (4-5 percent), you may consider hanging onto that debt.
Of course, if deflation strikes, you’re screwed. ☺
Final Thoughts
Don’t be fooled into thinking that repaying your debt is the risk-free choice, while investing is the risky choice.
Both choices are risky. Debt guarantees interest penalty. But if you repay your debt, you risk the loss of opportunity cost.
You’ll constantly face tradeoffs between risk and reward. The goal of personal finance is to manage your risk. That requires an honest assessment about the risk-reward balance of whatever you’re considering.
There’s no such thing as “no risk,” there’s only “smart risk.”
Photos courtesy Julian Stallabrass, Luke Wisley and roblisameehan.
I never really considered the inflation part of it before, but I guess that does factor in.
To me, the employer match is at the top of the list for deciding, too. I don’t get a match on anything from my employer (due to the tough economic times), so I’m focused on paying off my student loans ASAP (which will be complete less than a month from now!)
@Jeffrey — The inflation aspect is part of the reason that rental properties are such a good deal. Each year, the rent that you charge your tenants increases with inflation. Meanwhile, your mortgage stays the same.
Less than one month before your student loans are repaid?!?!? Congratulations!! That’s going to be an incredible feeling!
This is a very “personal” question. By that I mean that everyone will answer differently, based on their relationship with money. I really don’t know what I would do; it’s really easy for me right now to say that I’d rather invest it (I have no debt) but maybe I’d be singing a totally different tune if I were thousands of dollars in debt.
Both choices are fraught with risk. All that matters is which risk are you more comfortable handling.
Yeah. I hadn’t thought of inflation like that before either.
And for me, I invested in my employer’s 401k plan up to the match, then I focused on putting my first $1,000 in an emergency fund. After that, I threw all of my extra money toward paying off my ~$4,000 in private school loans. After that, I started padding my emergency fund. That ended up working perfectly for me.
The only thing that’s causing me heartache right now is the interest accruing on my federal loans. one day at a time, though.
For most people they should just repay debt, but if you are smarter with your money and dont just waist it then it depends like you pointed out.
Interesting post. Could you explain more about what you meant when you said you make money when you buy, not when you sell? Having trouble wrapping my head around this one… Thanks!
@Barbara — Let’s look at that McDonalds example again. Ignore the actual price of the stock, and just focus on the money you earn in dividends — your yearly “income” from the stock.
If you bought the stock at $74 per share, you’d have an 3.7 percent return. If you bought the stock at $98 per share, you’d only have a 2.8 percent return, which is far lower. Perhaps the better word choice would be to say that you “win or lose” when you buy, not when you sell. You “win” with a 3.7 percent return; you “lose” with a 2.8 percent return (which barely keeps up with inflation.)
Look at another example — the cost of a home. Let’s assume I borrow $185,000 to buy a rental property. The interest rate is 5% and property tax is 1.5%. At that rate, my monthly payment would be $1,224. Toss in an extra $50/mo for trash, $100/mo for water, $100/mo for repairs and $100/mo for management, and my costs are $1,574 per month.
In my neighborhood, I’d have a hard time finding tenants who are able to pay $1,600 per month to rent a mediocre property. This would be a losing investment that removes cash from my pocket each month, because I paid too much for it. In other words, I “lost money” or “lost the deal” or “lost the game” when I bought the house. (The price I might sell it for, in the future, is anyone’s guess.)
Depends on the type of debt and interest rate, doesn’t it? Unsecured consumer debt at nosebleed rate should get whacked as soon as possible. Real estate mortgages as you say provide *some* tax benefits, and benefit from future inflation, as you say.
I think one of the biggest mistakes people make in this analysis is anticipated returns. While stocks may average 8% or more long-term, the volatility is such that the risk-adjusted return is much lower than paying down fixed debt, even lower interest rate debt. Personally, unless it’s the 401K match (which is often 50%-100% return), I think paying off the debt is often the best bet in the near-term. With some perseverance and good fortune, there will always be opportunities to invest more later.
@Darwin — I’m certainly not a fan of gambling on what you hope the market (or housing prices) might do in the future. We just can’t predict the future.
That’s why I prefer dividend investing, rather than stock appreciation. It’s also why I prefer rental income, rather than flipping houses. To me, dividends and rent are “fixed-income” investments with manageable risk. Price-appreciation gambles (in both stocks and real estate) are speculative.
Yeah, this answer will change by the person. I figure as long as you’re got your liquidity handled with an emergency fund you can compare rates. When it comes to things like student loans and mortgages, you might be getting a government boost – so take that into consideration.
What rate do I draw the line at? Somewhere between 1% (keep the debt) and 20% (pay it down). I know it when I see it, haha.
@PKamp3 — I struggled with this question a lot when I got a mortgage on my rental-income house, which is the first and only debt I’ve ever had. Should I accelerate the pay-down? Or should I put all my money towards a down payment (read: MORE debt) on a second rental property? My “gut” wants the mortgage gone, but my “head” knows I’d be better off in the long run if I buy another rental property. So I’m pushing my comfort zone and buying a second rental property ….
When you are debt free, there is this wonderful feeling that you may not experience often. It is called freedom. You will understand once you make your last payment (with or without a mortgage). No amount of financial bean counting, such as borrow to invest schemes, can ever bring about that feeling.
> you make money when you buy, not when you sell?
I know people who buy homes with cash because it removes so many layers of risk (for the seller) that they are often willing to go down in the asking price. If you were buying this to resell, you worry less about what you have to resell it for now.
Thanks for the explanation…that makes sense!
Great explanation. The problem with personal, high interest debt (ready credit card debt) is that it’s usually at far higher interest rate than pretty much any investment you can make and as you mentioned, even the most ‘guarantied’ investment types one makes involve some risk (rental market could go sour etc.) Besides employer matching your 401k contribution, for credit card debt, virtually no investment is worth not paying off that balance and getting rid of that debt since the average interest rate on credit cards is just shy of 15%. Low interest mortgages, student loans, car loans etc. is where you have to do the investment vs. debt paydown balancing act.
@Azra — exactly. Everyone agrees that credit-card debt should be paid off immediately, but people have different reasons for thinking this. Some people think it’s because debt “traps” you; others say it’s because you’ll never find an investment that outpaces that interest rate. Deciding your underlying “why” when it comes to repaying debt — your mindset — is the key here.
I’m a little late on commenting but I wanted to add one thing to this discussion re: inflation and debt.
The current economic crisis came about because of too much debt (both good and bad). By increasing the amount of money in circulation, (Quantitative Easing version 3 coming soon to a Federal Reserve Bank near you), the Fed decreases the value of the US dollar. Debtors benefit from a weak dollar since they borrowed expensive money and are paying their loan back with it’s weaker version. Plus, the Fed keeping inflation at bay by maintaining low interest rates also benefits the borrower.
Who gets screwed? The saver, investor and those on a fixed income.
@Betty — That’s why I’m such a fan of getting mortgages on rental properties right now. We’re (probably) heading for inflation — and more importantly, house prices + mortgage rates are low while rental prices (in many areas) have remained high. It’s the perfect storm …
I’m a believer in paying off debts first (non-mortgage debts), then building an emergency savings before beginning to invest.
Debt management programs are great to get you out of paying the interest rates, so you can pay down your principle. In a few years you can have your credit card paid off.
I would pay down debt first, start an emergency fund and then invest.