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.”
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.
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. ☺
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.”