During a recent Twitter discussion I was asked; “How do you balance attacking debt at the sacrifice of missing opportunities along the way if all expendable income is thrown at debt?”
Do you need to be 100% debt free before you begin investing? Are you really sacrificing opportunity if you choose to attack your debt before you attempt to invest your capital? Are you truly comfortable investing using leverage?
This is an easy answer when faced with high-interest credit cards. A 22% APR from Visa is like an anchor that is going to drag you down quickly. It makes no sense to pay minimum payments on a 22% credit card while investing into a stock market returning 7%. At least I hope that doesn’t make sense to you – sadly, it does to some. Sweet mercy…
A debt of 4-8% APR, however, doesn’t seem like that big of a deal when the stock market offers a chance for bigger annualized returns. This is the APR neighborhood where mortgages and student loans tend to hang out. It’s also the neighborhood where people start forgetting they can’t beat math.
I always baseline the discussion by asking; “If you were debt-free today would go borrow money at the same interest rate and then turn around and invest it in the stock market?” A “yes” is to essentially invest using leverage – the use of debt to undertake an investment. A “no” would indicate you’ve balanced the risk versus the reward and favor being debt-free.
During a quick Google search exploring this topic I found my way to The Motley Fool, one of the absolute worst financial websites on internet. In seeing them tackle this topic, I found what I felt to be a very foolish argument for hanging onto mortgage debt. The Fool writes:
If you owe $300,000 on a 30-year mortgage at 4.64%, your monthly payment will be around $1,545, and you’ll pay $256,241 in interest over 30 years. If you pay an extra $960 per month toward your mortgage on top of your minimum payment, you’d have your mortgage paid off in 13 years and six months and save $152,577.41 in interest.
The Fool continues: This sounds good, except you wouldn’t have been able to invest for 13.5 years. If you’d instead paid just your minimum mortgage payment and made $960 monthly 401(k) investments over this time, you’d have $243,197, assuming a 7% return.
The Fool ends with: After 13.5 years, you’d still owe $212,768.93 on your mortgage. You could pay off the entire mortgage balance with your $243,197 in savings if you wanted to and still have around $30,400 left. In this case, you’re better off investing because the interest rate on your debt is lower than what you could likely earn.
Alright, let’s break this down. In this example we are trying to determine where to invest an extra $960/month we have at our disposal. Should we pay down our mortgage [attack our debt] or invest in the stock market [what we’ll refer to as ‘opportunity’]? According The Fool, the delta is $30,400 in favor of investing in the stock market. For the sake of the exercise I’m going to say we’re debt free except for this mortgage…
First – The Fool is equating the risk of the stock market to the absence of risk in the mortgage repayment. If you put the extra $960/month toward your house for 13.5 years your guaranteed savings is $152,577.41. Done, end of story. That is the amount you will save in interest. If you put the $960/month into the stock market the Fool is assuming a 7% rate of return and an ending balance of $243,197. Did you catch that? He is assuming – that’s his word, not mine. There is risk that is not being factored in here. The market could deliver 7%, but it could also deliver less. Just 10 years ago the market ended its worse 10-year average return period in history, delivering -3%/year on average in the 10 years ending Feb. 2009. That risk cannot be compared equally to the sure thing of a mortgage repayment.
Second – let’s look at the delta of $30,400 The Fool is touting while assuming this 7% rate of return. If I take the $960/month and pay off my mortgage I would then have that $960 PLUS $1,545 (my old mortgage payment). That’s a total of $2,505/month to invest. Unlike The Fool, I don’t have to assume a rate of return at all to see that in a mere 12 months I have that $30,400 saved. Even at 0% interest $30,400 / $2,505 = 12.14 months. This is done with no risk, only a 1 year time difference, and with a guaranteed result. I will take that sure thing any day!
Third – later in the article The Fool begins to tout the tax savings of the mortgage interest rate deduction, a common fallacy. Under current tax law, your “break even” mortgage where you can itemize the interest versus the new, higher standard deduction is over $500,000. That means it’s a non-factor in this comparison. I’m going to give The Fool the benefit of the doubt and assume he didn’t hear about the new tax law before writing this article.
Lastly – The Fool endorses investing your extra $960/month into your 401k and then withdrawing the funds to pay off your mortgage after the 13.5 years of investing. Absolutely foolish. The 10% penalty for withdrawing money out of your 401k prior to turning 59 1/2 obliterates any advantage of this plan. Unless he’s assuming you took on this mortgage at age 46, this is a horrible plan.
So this is one example. Your situations will be extremely fact-dependent with other tax, saving, and financial considerations. My point is you can’t always assume that a debt with an interest rate lower than an assumed return on investment is a debt worth keeping around. Be very, very careful turning your back on debt and focusing your attention to stocks & bonds with the allure of bigger returns. You can’t assume you are missing opportunity. Do the math…
You can’t assume anything about the market other than risk. You can’t assume anything about a mortgage other than what it is going to cost you. Paying $256,000 worth of interest on a $300,000 loan over 30 years is my idea of insanity. Debt is a master who knows no mercy, and you simply cannot put a price, or an APR, on freedom.
Cheers, and thanks for reading… thoughts?