| Using investment to pay off debt |
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Grains
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| Using investment to pay off debt |
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Hi, I have an investment account which I partially live off of, and I am wondering if it would be wise to take some money out to pay off debt and catch up. Thank you for any thoughts you all may have.
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Thu Oct 23, 2014 1:22 am |
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oldguy
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Sounds backwards to me - I use debt to pay for investments.
But why do you want to get rid of debt, is your interest rate higher than your investment returns?
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Thu Oct 23, 2014 2:23 am |
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Grains
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Thanks for your reply. Why wouldn't you want to get rid of debt? Isn't that a favorable goal, to be debt free? Yes credit card interest tends to be higher than investment returns.
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Thu Oct 23, 2014 2:28 am |
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Publius
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It depends on a few things. From a mathematical standpoint, it depends on the rate you are paying on the debt vs the return on the investment as well as any favorable tax treatment of the interest you are paying. For instance, if your debt is mortgage debt at 3.5% and you are able to write that interest off of your income tax all while your average investment returns are 9%, you come out ahead by using that leverage to remain invested. Conversely, if the debt is credit card debt (the interest for which cannot be written off) at 18% and you are making 9% on your investments, you are losing 9% a year by not using the investments to pay off the debt.
The other side to this is your tolerance for risk and attitude toward debt. Oldguy is of the opinion that leverage is always good if it is used in a way that comes out ahead mathematically. Many people have a negative relationship with debt and it may be personally beneficial to be rid of debt whether it costs you a few % or not.
From your post, it sound like your debt is of the high APR variety and it is likely that you would benefit by using investments to pay it off.
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Thu Oct 23, 2014 4:01 am |
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Wino
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I'm with Publius on this one. It is a rare investor who has cash to buy what he wants, but borrows money anyway to play the "spread" of the rates. For example, if you have a million in the bank, you can buy a $250K house, and if your investment falls to $500K, you still have enough to pay your bills, but in the same situation, if you have only $250K and it falls to $125K, you're still stuck with coming up with the money to make payments, PLUS you're losing the interest rate amount on top of the market drop.
Risk is real, and needs to be accounted for. How do I account for risk? I minimize it by NOT leveraging my debt versus my investments. I don't need an extra 4% per year, with the occasional near-bankruptcy or panic when the market falls precipitously. I invest money I can "lose" without bankrupting me. I have no debt, except my house (DW "needed" a new car this year, or else the house would already be paid off), which will be paid off well within the next 12 months.
Could I pay off the house earlier? Yes. Will I? No. I prefer to continue my investments while paying off my debt. In that regard, I disagree with Dave Ramsey's plan. I think it is plain stupid to forego up to 5% extra salary from a 401K match, just to pay off some debt a year or two earlier. Also, Roth is limited to about $11K per year per couple. If I pay off debt, I could invest an extra $10K (or whatever), but it can't go to Roth, because I'm time-limited on that account. I can't go back in 2015 and make 2014 Roth investments (I am ignoring the January to April rule for simplicity's sake).
Short answer: Yes, paying off debt is good, even if mathematically it might make you more money to leverage your investments. Credit card debt is almost never good. Maybe one could come up with an anecdote that shows how 18% is better than nothing, but in at least 99.99% of the cases, borrowing for Starbucks, a new car, or some other toy or wasteful spending is not the smart thing to do.
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Thu Oct 23, 2014 11:44 am |
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littleroc02us
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For my family who doesn't have a doctor's salary, we feel that debt is just an unnecessary block to gaining wealth. The more payments you have, the less money you have to invest with, unless you like taking huge risks and using debt to invest with. As for your situation, if your of the mindset that you hate debt and will never go back into it for anything, then I would use some investments to pay off your debts. If your just going to go right back into debt because you have no discipline, then I would say def not. As for interest rates, that matters not to me, if you are worrying about rates then your really not interested in being debt free.
My family has become very wealthy and successful, because we are awesome savers and don't foolishy buy materialistic items. I sit there and watch most of my friends buy fancy cars, lease cars, boats and buy 4000 sq foot homes, but they have no investments. Crazy! My wife and I always joke that when we retire and move somewhere warm, were gonna have to make new friends, because our friends won't be able to afford a tropical home.
Once you pay off those debts, then I would concentrate on putting 15 to 20% of your income into Index funds through Vanguard or J.P. Morgan that have low expense fees. That 15 to 20% does not include employer matches, that is just butter on the bread. Good luck!
Risk comes from not knowing what you're doing. (Warren Buffet)
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Thu Oct 23, 2014 2:07 pm |
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littleroc02us
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quote:
Originally posted by Wino
Could I pay off the house earlier? Yes. Will I? No. I prefer to continue my investments while paying off my debt. In that regard, I disagree with Dave Ramsey's plan. I think it is plain stupid to forego up to 5% extra salary from a 401K match, just to pay off some debt a year or two earlier. Also, Roth is limited to about $11K per year per couple. If I pay off debt, I could invest an extra $10K (or whatever), but it can't go to Roth, because I'm time-limited on that account. I can't go back in 2015 and make 2014 Roth investments (I am ignoring the January to April rule for simplicity's sake).
I disagree, what happens if in that year or two that your paying off your debt the market crashes like it did in 2008 and 2009 and you lose a ton of money, when you could have had a gauranteed return of whatever the interest rates were on your debt. That is the risk your taking when you fail to pay off your debt. Dave Ramsey has it right.
As for paying off the house. That is something I strive for with my rental and my primary. On both properties I throw a couple hundred dollars extra each month and my renters are paying off that property for me, but when I retire someday, my rental properties that will be paid off will be cash flowing my retirement big time. That doesn't include all of my roth investments and 401k's. Social security? That's fun money.
Risk comes from not knowing what you're doing. (Warren Buffet)
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Thu Oct 23, 2014 2:16 pm |
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Grains
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Thanks everyone for your responses. A lot to consider. Little roc, my income comes from from various investments, so I don't know how the 15-20% would work, maybe reduce income by that much or reinvest?
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Thu Oct 23, 2014 2:55 pm |
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littleroc02us
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What type of investments? Are you retired? Do you have a job? Age?
Risk comes from not knowing what you're doing. (Warren Buffet)
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Thu Oct 23, 2014 4:19 pm |
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Grains
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Right now I'm a 53 year old stay at home mom busy driving kids around, etc. investments are in a trust with cash, mutual funds, etc. plus I get additional stock dividends. I've got no other debt, no mortgage, no car payments, just high expenses (two kids in private school, high electric bills, kids activities and so on.
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Thu Oct 23, 2014 5:40 pm |
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littleroc02us
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Crazy question, but how to you put kids in private school if you don't have a job. So why don't you have a job?
Risk comes from not knowing what you're doing. (Warren Buffet)
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Thu Oct 23, 2014 6:59 pm |
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Grains
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I am fortunate to have enough investments to live off of the dividends, and I stay at home to take care of my home and children full time. (A lot of people do)
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Thu Oct 23, 2014 7:55 pm |
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littleroc02us
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quote:
Originally posted by Grains
I am fortunate to have enough investments to live off of the dividends, and I stay at home to take care of my home and children full time. (A lot of people do)
Ok, so why do you have debt then?
Risk comes from not knowing what you're doing. (Warren Buffet)
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Thu Oct 23, 2014 8:14 pm |
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Grains
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I have not built an emergency fund and accumulated some debt. Unexpected things come up sometimes so now I am trying to figure out the best way to eliminate the debt
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Thu Oct 23, 2014 8:17 pm |
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Wino
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quote:
Originally posted by littleroc02us
I disagree, what happens if in that year or two that your paying off your debt the market crashes like it did in 2008 and 2009 and you lose a ton of money, when you could have had a gauranteed return of whatever the interest rates were on your debt. That is the risk your taking when you fail to pay off your debt. Dave Ramsey has it right.
By the same token, what if you were paying off 4% debt instead through this year? The market is up close to 20%, even with the recent dip. So, I would have lost that "gain" along with paying off debt instead of investing in my Roth, which I will NOT be able to recoup ever. I see the "what if" in this case more as market timing, and less as risk avoidance. Nota bene: I'm saying that the "what if" is market timing, and not a valid argument for paying off the debt one or two years earlier.
I don't get any employer plan, so I'm fairly much stuck doing only an individual IRA (Roth, in my case). I can't do the $18K (next year) in a 401K, I don't qualify for a SEP, as I'm not self-employed. So, my choice would be to put $13K toward my mortgage, or $13K toward my Roth (over 50).
A quick calculation shows that $26K over ten years at 12% interest per year turns into $80K. That's $54K I'd be giving up just to pay off my debt two years earlier. Also, that $54K will be tax free when I pull it out. (This is for illustration purposes; I am already past this point in my scheme, so I'm at the two-year point already, less DW's car. Also, $13K for two years won't pay off my house very much more quickly, anyway).
Now, let's take someone more "normal" in his life. He makes $50K per year, and his employer matches 5% maximum per year in his 401K. The subject person invests $5K in the employer plan to get the 5% match at 50%. That's $2500 per year from the employer. I think that such a plan is probably fairly common or close to most mid-sized to large-sized company plans. That employer $5000 (2 years at $2500) over ten years turns into $15K at 12% interest. This is "free money" that only had to be paid for by investing 10% of his salary into his company plan. He invested $10K over two years to earn $10K 10 years later, instead of paying it toward debt.
I am all for paying off all credit card debt quickly, but the employer match should be grabbed every year, unless you're just drowning in debt. If you can't make your minimums, and all of your debt is high-interest credit card debt, then you're paying too much for the money to invest, and doing so would be stupid. If your debt is cars (3% or less if you have good credit - DW's rate was 1.19%), home equity (typically also 6% or less), and a home (typically 4% or less - if you have 5% or more, you should refinance), then you should be taking advantage of the tax-advantaged plans that are available, as well as the match of your employer.
I am not advocating borrowing to invest. I'm advocating paying off the debt somewhat more slowly for specific financial advantages. To mention these specifics again: employer match, future tax savings, and investment opportunities that will not be available after end-of-year. I'm really, really opposed to foregoing the employer match, except to pay off double-digit interest rate debt.
(Sorry for hijacking the thread)
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Fri Oct 24, 2014 12:41 pm |
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