Photo Credit: Mike Cohen || Certainty versus volatility
One question that many ask is “Should I invest or pay down debt?” Let me quote from a prior article Retirement — A Luxury Good.
What is a safe withdrawal rate?
A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That’s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.
How should you handle a significant financial windfall?
If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce your debt. If the windfall is still greater than that, treat it as an endowment fund, invest it wisely, and only take money out via the safe withdrawal rate formula.
I have been debt-free for eighteen years. Being debt-free enables me to take more risk with my assets if I think it is warranted. At present, I think that if someone has debts with interest rates higher than 3.4%/year, it makes sense to pay down debt rather than invest more. Now there may be tax reasons why one would not liquidate assets to pay down debt, but if you have free cash not needed for a buffer fund, then use the excess cash to pay down debt. Don’t use the Dave Ramsey method, which is stupid. Pay down the highest interest rate debt first.
I can say this with greater confidence at present, because most stock portfolios and private equity portfolios will lose money in nominal terms over the next ten years much like the 2000-2010 decade. Valuations are comparable to that of the dot-com bubble, and unless you are invested in stocks with low valuations and low debt, you will get whacked when the next crisis hits, as growth stocks will decline by more than 50% unless the Fed intervenes, which it might NOT do if inflation is hot.
All other things equal, a debt-free lifestyle is pleasant — there is less worry. Anytime you lower the amount of money that must go out each month, life gets easier.
What’s that, you say? When would I be willing to invest rather than decrease debt? If I had an investment that I thought would return more than 7% over the interest rate of my highest yielding debt, I would invest, assuming that the investment has a sustainable competitive advantage.
I’ve given two rules here, and there is a considerable possibility that neither rule may apply. In that case, do half. Take half of the excess cash and pay down debt, and invest the other half. The “Do Half” rule exists to make good decisions easier when situations are uncertain. It’s not perfect but it will give you the second-best solution. And if you always do second-best, you are beating most of the world.
My bias is to pay down debt. It’s a happier lifestyle, and most people don’t do well acting like mini-hedge funds — borrowing to invest. In a bull market, it looks like genius, but when the bear cycle hits it is traumatic, and many don’t survive it well, particularly if they get laid off.
With that, in the present environment, I encourage you to reduce debt. Unless you invest in unpopular stocks, as I do, future returns will be poor. Reducing debt gives you a relatively high return, and with certainty. Take the opportunity to reduce debt when it makes sense.
People should not only think of investments as stocks or real estate. Think like a company and make profitable capital improvements. I live in a high cost electricity state. I got >8% (tax free) return on putting in solar. Look at your heating or air conditioning. Does your utility offer incentives for insulating. Picking the low hanging fruit in this area can reduce your cash outlays over time – and they aren’t taxable by the government.
In my area, Maryland, I have more friends trying to figure out how they can terminate rooftop solar agreements. Very costly to them.
The key here is electricity is $.25 / kwh. Plus I get a cash payment from the utility on top of that. And I bought the panels. People who leased them have all sorts of issues.
Its true that FANGMAN stocks are richly priced, but US Treasuries are even more overpriced given their ability to repay.
A bunch of octogenarians (from both Democrat and Republican organized crime families) are “borrowing” money they won’t even be alive to repay… obviously Uncle Sam is going to default. It doesn’t matter if previous generations paid their bills, this group does not. US Treasuries are not an investment, they are junk bonds that pay sub CPI interest rates.
Of course, the US government did not engage in “torture”, it uses “enhanced interrogation” techniques. And equally clear, US Treasuies won’t “default”, they will have “politically expedient involuntary restructuring”. Fancy labeling, same outcome. A default by some other name…
A penny saved is a penny earned: Paying down debt saves whatever mortgage interest rate, if not whatever credit card interest rate. Owning a bond that defaults (oops! involuntary restructuring) means a big loss.
When deciding when/if to pay down debt of something like a mortgage, you also have to consider that the interest you are paying is tax deductible and if you are in a high tax bracket that can be effectively a much lower rate than at first glance. With a mortgage, all things being equal you don’t want to pay it off too fast and avoid investing because investments return is compound interest that gains more year after year whereas a mortgage is simple interest that gets smaller over time. In other words, something like a 2% return on a treasury will be more valuable long term than paying off a 3% mortgage early (even ignoring tax benefits of the mortgage).
A 2% compound interest on $100,000 will yield about $81,000 of gain over 30 years. A 3% mortgage of $100,000 will cost about $52,000 in interest over 30 years.
It is very unusual for most Americans to stay in a home for 30 years, unless they are a retiree. The average time in a house (and not coincidentally the rough effective duration on a mortgage security) is 8 years.
According to bankrate.com, the average mortgage today costs 3.29%, or 2.47% after tax assuming a 25% marginal tax rate. The yield on the 10yr Treasury at yesterday’s close is 1.3%, and you must pay federal taxes on that income. sorry man, but there is no way to pay 2.47% and receive 1.30% and come out ahead financially. If you take a small number minus a big number and come out in the plus column, then you are really bad at math.
People invest their rainy day funds in Treasury mutual funds because they are liquid — and if the $#% hits the fan you need liquidity. It is never to make money.
The reason to take out a mortgage is to build equity, not to get a tax deduction. For most Americans, building equity in a home is the number one way to save and build wealth — or it has been historically. Whether this is still true today with elevated home prices and high property taxes is a separate discussion and depends on location. If you have cash for a down payment and your credit rating is OK, why would you build equity for your landlord instead of building equity for yourself?
If you are in the top tax bracket (instead of the 25% marginal bracket assumed previous paragraph), odds are you own a business and you should be building equity in your business (because the expected return is ~10% or more, unless the business is in trouble). Earning 10% gross (~7.5% after taxes?) while paying 2.5% on a mortgage makes financial sense.
When stocks are priced at their historical norm (with expected returns around 7-8% pretax), it might or might not make sense to invest instead of paying down a mortgage — because 7% is only on average, and the standard deviation of returns is really wide. Today, David’s stock return model is predicting 0% average returns (see his post from a month or two ago). GMO asset management also publishes a 8-10yr expected return forecast, and they are predicting negative 1% average expected return. Stocks are currently priced really high, so they have a lower than historical average expected return. Paying down a mortgage today makes more sense than investing in stocks at current prices. IG bond yields are so low that they aren’t worth mentioning except for their diversification benefit on existing portfolios — not worth adding to.
One gets a guaranteed return of 3.4% paying down a mortgage, versus expected returns much lower than that on listed securities. Paying down home equity or (gulp) credit cards has an even higher return. There is no guaranteed return on stocks, while bonds fail to keep up with inflation even on a pretax basis.
1) the length of time you will stay in a house is unrelated to the math of paying off a mortgage early or not in comparison to investing
2) similarly you should not limit yourself to a 10 year investment if you are trying to analyze the long term difference in outcomes of financial decisions since you would not be forced to liquidate an investment after 10 years. 30 year treasury rates are still 2% and there are obviously an infinite number of investment options likely to return >>>2% over 30 years.
3) compound interest vs simple interest. It’s the miracle of why a smaller compound return can outperform even a larger simple interest payment over a long timeline.
Dude!!
1) Actual holding period does matter. If you stayed at the roulette table three times longer than you actually did, perhaps you might win. Or not. Maybe your house holds value if you stay 30 years. Maybe your house is in Detroit. Woulda, coulda, shoulda doesn’t matter. Actual holding period does matter
No one is “forced” to sell their home after 10 years, but most people do. They change jobs. They “upgrade” to a bigger, better house in a better school district. They move closer to family. They saw a ghost in their old house. It doesn’t matter why. Most people move within 10 years, and its been that way for many decades (before MBS)
2-3) You started off arguing about the tax incentive of a mortgage, but now you flip flopped over to the advantages of building equity (paying off your mortgage on schedule, or paying it off early). You defeated your own argument.
Building equity matters. The tax writeoff, as you tried to argue initially, does not matter
I suggest simply building yourself a spreadsheet with actual numbers and see for yourself. You not wanting to believe the true difference between simple and compound interest is a common misunderstanding.
That is cheap. In Germany we pay at least 0.3 Euro Cent/ kwh