You’ve heard the adage should I invest or pay off debt? Do I do both? Is one strategy better than the other? It seems that this question is always raised by people we engage with. The answer is specific to each individual, family, and business. The optimal strategy is part of what is included in a Financial Life Plan. To provide some insight, I thought I would spend some time to review some of the determinants that goes into this. Here are some general considerations and advice.
Investors face the dilemma of whether to pay down debt with excess cash or to invest that money to turn it into even greater amounts of wealth. If you pay off too much debt and reduce you leverage, you may not garner enough assets to retire. Conversely, if you're too aggressive, you may end up losing everything. In order to decide whether to pay down debt or invest, you must consider your best investment options, risk tolerance and cash flow situation.
From a numbers perspective, your decision should be based on your after-tax cost of borrowing versus your after-tax return on investing. Suppose, for instance, that you are a wage earner in the 35% tax bracket and have a conventional 25-year mortgage with a 3% interest rate.
If you hold a diversified portfolio of investments that includes both equities and fixed income, you may find that your after-tax return on money invested is higher than your after-tax cost of debt. For example, if your mortgage is at a lower interest rate and you are invested in riskier securities, such as small cap value stocks, investing would be the better option. If you're an entrepreneur, you also might invest in your business rather than reduce debt. On the other hand, if you are nearing retirement and your investment profile is more conservative, the reverse may be true.
“Too many people spend money they haven’t earned, to buy things they don’t want, to impress people they don’t like.” Will Smith
When determining risk, consider the following:
- Your age
- Earning power
- Time horizon
- Tax situation
- Any other criteria that's unique to you
For example, if you're young and able to make back any money you might lose and you have a high disposable income in relation to your lifestyle, you may have a higher risk tolerance and be able to afford to invest more aggressively versus paying down debt. If you have pressing concerns, such as high healthcare costs, you may also opt not to pay down debt.
Rather than investing excess cash in equities or other higher-risk assets, however, you may choose to keep greater allocations in cash and fixed-income investments. The longer the time horizon you have until you stop working, the greater potential payoff you could enjoy by investing rather than reducing debt, because equities historically return 10% or more, pretax, over time.
A second component of risk tolerance is willingness to assume risk. Where you fall on this spectrum will help determine what you should do. If you are an aggressive investor, you will probably want to invest your excess cash rather than pay down debt. If you are fairly riska averse in the sense that you cannot stand the thought of potentially losing money through investing and abhor any kind of debt, you may be better off using excess cash flow to pay down your debts.
“Happiness is not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort.” Franklin D. Roosevelt
However, this strategy can backfire. For instance, while most investors think paying down debt is the most conservative option to take, paying down, but not eliminating debt, can produce results that are the opposite of what was intended. For example, an investor who aggressively pays down his mortgage, leaving him with a very meager cash reserve, may regret his decision should he lose his job and still need to make regular mortgage payments.
Cash and debt
Financial life planners suggest that working individuals have at least 6 months' worth of monthly expenses in cash and a monthly debt-to-income ratio of no more than 25 to 33% of pretax income. Before you begin investing or reducing debt, you may want to build this cash cushion first, so that you can weather any rough events that occur in your life.
Next, pay off any crdit card debt you may have accumulated. This debt usually carries an interest rate that is higher than what most investments will earn before taxes. Paying down your debt saves you on the amount that you pay in interest. Therefore, if your debt-to-income ratio is too high, focus on paying down debt before you invest. If you have built a cash cushion and have a reasonable debt-to-income ratio, you can comfortably invest.
Keep in mind that some debt, such as your mortgage, is not bad. If you have a good credit score, your after-tax return on investments will probably be higher than your after-tax cost of debt on your mortgage. Also, because of the tax advantages to retirement investing, and given the fact that many employers partially match employee contributions to qualified retirement plans, it makes sense to invest versus paying down other types of debt, such as car loans.
“Buy when everyone else is selling and hold until everyone else is buying. That’s not just a catchy slogan. It’s the very essence of successful investing.” J. Paul Getty
Well that’s a lot of jargon and financial speak. In may be easier to plug in some numbers. Here is a case in point for the small business owners in the crowd. If you are self-employed, having cash on hand may mean the difference between keeping the doors open and having to go back to work for someone else.
Let’s demonstrate. For example, suppose that you have a fairly tight cash flow gets an unexpected windfall of $10K and you have $10K in debt. One obligation carries a balance of $3K at a 7% rate and the other is $7K at an 8% rate.
While both could be paid off, you have decided to pay off only one, to conserve cash. The $3K debt has a $99 monthly payment, while the $7K debt has a $67 monthly payment.
Conventional wisdom would say you should pay off the $7K debt first because of the higher interest rate. In this case, however, it may make sense to pay off the one that provides the greatest cash flow yield. In other words, paying the $3K debt off instantly adds nearly $100 a month to your cash flow, or almost 40% cash flow yield ($99 x 12/$3K). The remaining $7K can be used to grow the business or as a cushion for business emergencies.
The bottom line
Well, I know some will argue against the logic used in the prior example. That’s ok and that’s the point. Different methods can be applied depending on each specific situation. Knowing whether to pay down debt or invest depends not only on your economic environment, but also on your financial situation. The trick is to set reasonable financial goals, keep your perspective and evaluate your investment options, risk tolerance and cash flow. This may not be in the wheelhouse of some individuals or businesses so engaging a financial life planner can be an asset to provide valuable advice in Keeping Life Current.
Steve is the SBCN Community Mentor and can be reached at steve@NorthernRiverFinancial.ca