Sometimes, I find myself fantasizing about what I would do if I had extra money. I've been following the stock market a lot lately and thinking, well, if I could find $5,000.00 to invest, I bet I could turn it into (unrealistically) $10,000.00 with very careful execution. (The truth is under the "Rule of 72" it takes 7.2 years to double an investment with a 10% annual return; thus, to double an investment in just 1 year would require an annual return of 72% -- but, I'm dealing strictly in fantasy here). In any event, would it make sense to take the $5,000.00 and invest in something or take the $5,000.00 to pay off debt?
I actually cannot answer that question for you, but I can help you add some understanding to how you ought to think about it. You have to compare apples to apples, first of all, so you need to know the after-tax returns of paying off the debt and the after-tax returns of investing the money. Thus, the equation is different when we are talking about paying down a mortgage, which at an interest rate of 6% has an after-tax rate of approximately 4% (depending on your tax bracket and state tax) versus a credit card with an interest rate before and after taxes of the same amount, let's say 14%. Of course, not all mortgages are 6% and not all credit card or other debt is 14%; the point is the same, though: after tax interest rates are what you need to figure out.
The same is true when looking at the investment side of the equation: in other words, if you are investing in something with a 10% return, you have to deduct any taxes you have to pay from that return. And of course, you must deduct commissions and fees from that return and any other costs of investing such as obtaining investment advice. So, if you hold certain investments for the requisite period of time, or you invest in certain types of instruments, you may get favored tax treatment. And in a retirement account, you do not pay taxes on the growth until you withdraw (if at all). However, if it is a taxable investment, you have to reduce your results by any state and federal taxes you might pay (favorable tax treatment can make that as little as 15% on the federal side, and your state tax can be as high as 10% or as low as 0% depending on where you live; however, if you do not get the capital gains rate, you will pay for investments the same way you pay income taxes -- up to 33% for federal taxes). Thus, your 10% return may become an 8% return or less.
So, aside from an investment in retirement savings, should you invest money before you have fully paid off your debt other than your mortgage or other low-interest debt? I think if you account properly for risk when investing, you are likely to decide that it makes more sense financially to pay off debt rather than invest money.
Let's just say you have a hot tip on a good stock and you believe that you will see 15-20% return in a year, after commissions and fees (which you must factor into both sides of the buy-sell). If you really thought you could get a 15-20% return on your investment and you reinvest the return, compounding it, you would actually create a sizable amount of money. At the same time, if you make the investment, you still have to pay down your debt with a 15% interest slowly over time. If you forego the investment, you can use the money to pay off the debt. What should you do?
It depends on your level of risk taking with which you are comfortable. If you had taken that $5,000.00 and invested in the NYMEX IPO last week, I think you would have doubled the money in a day. Surely, jumping in and out of the market like that would be a great deal, if you can do it so easily. You would have walked away with 10,000.00, and paid taxes of approximately $1800.00 (in a 28% bracket with a 6% state tax and $100.00 in fees all of which you can adjust accordingly for your own situation) leaving you with $3200.00 in profit and your original $5,000.00 investment to pay down your credit card. If only we could invest like that every day, then, there would be nothing to talk about.
Suffice it to say, however, that had you bought the Hertz IPO on that same day (which, if you listen to Cramer, you would not have, but, if you don't, you might have), you would have lost a portion of your original investment and the same could be said of any other stock: you could have gained, you could have lost. But, assuming that you honestly believe that you can turn an above average return of about 15% on the stock, should you invest and hold it for one year or should you pay down your debt?
I think you need to pay down your debt that is above 10%. The reason is this: if you compare your return, by paying off the $5,000.00 in debt, with 15% interest, you will save $700.00 in interest (assuming you pay the minimum payment only) during the 1st year. (I actually calculated the amount based on a minimum payment of 2.5% per month. A rough calculation would actually be $750.00 which is roughly identical to what you would make on the investment). That's the equivalent of a 14% return on your money. Stick with me here, math is not my strong suit so although I am trying to use math to make a point, you can do it without all the math potentially.
At first blush, it is a no-brainer. If you pay off the debt, you end up in one year saving about the equivalent of what you would earn in a year on the money. After taxes, you are actually down a few hundred dollars if you invest the money, so it does not make sense to invest rather than pay down debt. But, I decided to think about it a little longer term to see if a 15% interest payment over time, while you reduce your debt slowly, makes sense.
In the latter scenario, I reasoned that you put your money to work today with a rate of return of 15% a year and you leave it there for as long as it would take you to pay off the debt if you paid today's minimum payment until it was paid off. In other words, you put your money to work for as long as you would pay off the debt at $125.00 per month. Using a bankrate.com calculator, I found that a $5,000.00 debt at 15% interest paid at $125.00 per month takes about 4.5 years to pay off. Your total cost is $7,000.00. If, on the other hand, you invest money, as it grows, if the interest compounds, you actually make more money. Since the interest actually causes the amount to become higher each year, you would actually have $9,000.00 at the end of 4.5 years.
To me, at first, it seemed like I would then come out ahead. I would have paid out $7,000.00 but gained $9,000.00 over the same time period; thus, I would have earned $2,000.00 over paying off the debt today.
That result is completely at odds with how I have been thinking: I have been thinking that my financial results will be better if I get rid of my debt before I try to save any money. I save for retirement, but I do not attempt other savings while I am in debt. What if, instead of adding money to my debt repayment, I saved that money -- I had never considered that because it is counterintuitive; first, pay off debt, then save money.
So, the issue is, since $9,000 is more than $7,000, does deciding to invest today rather than pay off debt more quickly still make sense over the long term. In fact, some people advise radical methods of getting rid of debt like selling your house or other investments to pay off all your debt. Why do something like that if you will accumulate more wealth by using that money to invest? There are lots of reasons and clearly I am being a bit sarcastic because I know I will be better off financially when I am finally done with all this nasty debt. Not one financial advisor I have found recommends taking on debt to invest (although rich people do leverage their investments; so why shouldn't we?). So, it cannot possibly make sense to try to invest while you are in debt, can it?
No. One major issue is being consistent about paying down the debt. What if you do not keep putting money on the debt and, instead, pay only the minimum every month. You'll actually pay it back over 21 years and it will cost you at least $10,000.00 or more. So, right there, you have created an unnecessary risk of expending a far greater amount for interest payments. Additionally, by paying off your debt, you have an extra $125.00 per month in cash flow that can be added to another debt to reduce that debt faster. It is like dominoes: paying off one debt allows you to keep going and paying off more and more debt more and more quickly.
Additionally, though, the investment earnings really are not $2,000.00 more than the debt repayment because of several factors. First: taxes. The $4,000.00 gain will cost about $600.00 in federal taxes (at today's favored capital gains rate which may or may not exist in 4.5 years) and will cost anywhere from 0 - $400.00 in state tax (depending on your state tax). Thus, you need to reduce the $2,000.00 gain over paying your credit card by $600.00 (right in the middle of a 0-10% state tax rate). It is still $1400.00. Thus, mathematically speaking, it seems like the better bet.
Here's where a few other factors play out. First, there's a bit of the time-value of money. $1400.00 in 2011 dollars is actually less than $1400.00 in today's money. Thus, it is not a true gain of $1400.00. But even if it was, would it be worth it? I think not unless the potential gain is much higher than the rate of interest on the debt. That's because a guaranteed rate of return (the amount you save if you pay off your debt) is worth more than a speculative, risky rate of return. Any money lender will tell you that, that is what your credit report is about: a riskier rate of return is costlier. Plus, other than dividends that are reinvested, stock returns do not "compound." They move up and down, and sometimes, sideways; in fact, sometimes, you even lose money. So, other than reinvesting dividends (which is generally less than 15% in the highest yield stocks), you cannot assume a compounding interest return of 15% unless you can really do well in the market over time. If this year, your $5,000.00 makes 20%, you'll have $6,000.00 -- what if that $6,000.00 loses 10% next year, you'll only be ahead by $400.00. So, it would have to be an absolutely steady growth of 15% per year that would allow you to turn it into a profit of $4,000.00 in 4.5 years. It can happen; it does not usually.
I am back to where I started now: if I get an extra $5,000.00, what should I do?
I should still pay off my debt even though the rough calculations make it seem as though I'll come out ahead if I invest. Why? It has to do with risk. If I pay my debt, what is my risk versus my return? My return is what I save in interest payments, in this case, $2,000.00 over 4.5 years. So, my $5,000.00 investment returns are guaranteed at about 9.5% a year (roughly) while my risk is 0. An investment that pays 9% with a 0 risk is fantastic.
Of course, If I pay my debt, I lose opportunity to find an investment that will do better than the payment on the debt. That's an abstract risk, but it is a risk. In fancy terms, it is actually an "opportunity cost." If, on the other hand, I invest money, my risk is far more concrete: I can actually lose the money leaving me with both the debt and no earnings. But, a couple of other factors are at play.
The 15% gain on this fantasy investment is purely speculative. First, it may or may not happen regardless of what you think. Those who bought Amazon in 1999 must have thought it was a sure thing and here it is 2006 and they are still waiting to see their money return to them. Lots of things can happen in the stock market or in any of the other risky places that you could put your money to get paid a 15% rate of return. Unless you are loaning money at that rate and the person is an excellent risk (although no excellent risk would borrow money at 15%), there is no guaranteed, non-risky investment of such high returns. The surest thing out there are money market and CD's and those are running at 5% returns on the high side. So, 15% compounded and guaranteed is just not happening for the average person.
However, paying off your debt guarantees you a savings of $2000.00 (or, in non-monetary terms, 15%). That's a guaranteed return on your investment of $5,000.00. If you pay your debt today, you will absolutely, positively, save the amount of money you would have paid in interest by paying it over time. Why? Because you have no choice but to spend that 15% if you are paying off the debt over time. Thus, the guarantee might cost you the potential of a gain, but you cannot lose.
This is the main point in making a decision on whether to invest money or to pay off debt: what is the risk?
If the choice was a lower rate payoff versus a higher rate of potential return, the less risky choice is still to pay off debt; this analysis, however, may make you reach a different conclusion as to the right decision. So, for example, should you pay off a debt with an interest payment of 7% or 9% or even 6% for a good chance of gaining 15%. Maybe then you should invest the money. But, even with stocks, a good investment returns you maybe 8% over time; thus, given taxes and fees even those lower-interest debts should probably be paid off before you invest your money.
On the other hand, if your potential rate of return on an investment is much higher than your guaranteed rate of return on a debt repayment, you should consider making the investment. Thus, many people let their mortgage debt stand for years while they invest in other items -- if you pay 6%, under current tax laws (excluding many of those who are subject to the AMD), the real rate of return on a mortgage repayment is under 4% depending on your tax bracket. You can invest in virtually risk free items for 5% (money markets and CD's) and you can invest in less risky investments that could bring you in 8% (stock and bond index funds). That is not speculative, that is a conservative estimate based on today's stock market. Hence, choosing between throwing $5,000.00 on your mortgage or putting it in a non-speculative stock or fund is a different decision than throwing $5,000.00 on a high-interest credit card or investing it in the stock market.
(Not that I think paying $5,000.00 toward your mortgage wouldn't be worth it in absolute terms. My view is that although the interest is low, it is still a lot of money to have the use of the money for a long period of time. Putting extra money on a mortgage saves a lot of concrete money down the road; thus, I might invest a little before I pay off my mortgage, but I think that if my only debt was my mortgage and I had a choice between paying it down and investing, I might still pay it down -- but, I am really goal-oriented in terms of becoming debt-free so analytically, it may not be the right move; emotionally, however, I am very attached to becoming debt-free.)
When there is a higher interest rate to pay off the debt, the return has to be much higher to justify the risk that you might lose money and, on top of that, lose the opportunity to have saved that interest payment. On the other hand, what do you lose by paying off debt: perhaps, the opportunity to make a high rate of return. But the comparison has to be made -- how much risk is worth this rate of return versus my guaranteed return of 15% on my credit card. A speculation that you might make 15% per year is not good enough -- it has to be more than what you are guaranteed to save by paying off your credit card.
What about a smaller interest rate credit card? Even a 0% credit card? Look, a 0% is only 0% as long as you pay it back before it goes up. It buys you time to pay off debt, it does not actually pay off debt for you. Thus, I do not recommend avoiding that debt to try to make money in the stock market unless you really feel comfortable with the risk versus return. The way I think of it is that it is a gamble when you are essentially borrowing money to invest in any kind of investment in which there is risk. And, if you are in debt, you are borrowing to invest until your debts are paid off (at least with respect to credit card and other kinds of "consumer debt.").
That's fine with me if it is fine with you -- but, that is gambling, not investing. When the stock market is like it has been lately, a lot of us can forget what it was like not so long ago. Many are bullish, including myself (not that it matters, my only investments are in my house and my retirement). But I would never borrow money to make a bet on the stock market -- I have considered it; I do not do it because I see it as a bet. If you are trying to time the market to "make a killing" there are probably places where you can learn to day-trade. That's a whole different issue. If you use someone else's money to play the market, beware: the depression occurred in part because people heavily leveraged their stock picks. And, somehow, we may all think we would know when to get out, but if you owe money, you are less likely to pull out on a bit of a downturn or maybe you'll pull out unnecessarily because of fear. Either way, people who are desperate are not good at investing. So, unless you are comfortable with your level of debt, you should not be investing at all.
You should not allow fear to motivate stock market investments. If you invest with money you can afford, you can than afford to ride the ups and downs of the market. If you are betting with money you do not have, you cannot. Thus, you should not be investing until you can afford to invest.
So -- should you find yourself living my fantasy of having a few extra bucks, pay off your credit cards and bad debts. If extra money comes along and all the nasty debt is paid off, by all means, invest it however you think is best. But whatever you do, do not forget to account for risk when you decide whether to invest or pay down debt.
So, use extra money to pay off debts, sleep better at night, and, when you are done paying off debt, you can invest in peace.