Many young people who visit a financial advisor for the first time have the same basic question: “I’m sitting on a bunch of cash, and I’m not sure what to do with it.” To that, I always respond with the same four questions:
- Do you have any debt?
- Are you maxing out your retirement accounts?
- How much are your living expenses?
- How secure is your income?
For the purpose of this discussion, we’ll assume that the answers to questions two, three and four indicate that the person is maxing out her 401(k) up to the match, has a relatively secure income and will maintain an emergency cash reserve of three to six months of expenses. That leaves us only to worry about question No. 1. (For related reading, see: Using HSAs for Retirement.)
Comparing Your Options
Using cash to pay down a loan is equivalent to investing the money at a tax-free, risk-free rate of return equal to the tax-adjusted interest rate on the debt. That is a lot of words but as an example, if you pay off a credit card with an interest rate of 15%, you have effectively purchased an investment that guarantees you an after-tax rate of return equal to 15%. This is a very good idea. In today’s low interest rate environment, there is no other investment that pays a guaranteed return anywhere close to 15%.
As I sit here writing, the U.S. government (the closest thing we have to a guarantee) will pay you annual interest of 1.32% if you let it borrow your money for five years and 2.77% if you let it borrow for 30. If you are investing in a standard account, you then have to pay tax on the interest you receive. If you are in the 28% marginal tax bracket, your take-home returns are only about 0.95% and 2% respectively. (For related reading, see: The Advantages of Automating Your Financial Life.)
Tax-Deductible vs. Non-Tax-Deductible
There are a lot of different kinds of debt, but they can all be broadly categorized as either tax-deductible or non-tax-deductible. When deciding which loans to consider paying off, we first need to make all loans equal on a tax-adjusted basis. To do so, we start with the interest rate on the tax-deductible loan and subtract the marginal tax rate multiplied by the interest rate.
As an example, if you are paying 5% interest on a tax deductible mortgage and you are in the 28% marginal tax bracket, we would use the formula 5% – (28% x 5%) = 3.6%. This allows us to effectively compare the tax deductible mortgage to a non-tax deductible car loan.
Considerations Beyond Interest Rates
Loan Duration: The amount of time that the lender is allowing you to use their money should be an important factor in the decision. Paying off a one-year loan with 3% interest may make complete sense whereas paying off a 30-year loan with the same interest rate may not. The reason has to do with your investment alternatives. With a short investment horizon (you know you’ll need money to pay back the loan), the investor can’t afford as much volatility and would be limited to short-term, high-credit quality bonds. On the other hand, 30-year money could be more comfortably parked in something like the stock market with more volatility and greater long-term upside potential.
Liquidity Needs. Another important consideration is liquidity. If you think you will need the cash in the near future (you have a wedding, want to take a trip, you’re buying another home), paying off debt may not be the best option even if the interest rates on the loans are higher than the interest being earned in your checking account.
Unique Circumstances. In addition to the above, there are unique circumstances that would make paying off a loan more or less attractive. For example, let’s say you bought a house for $500,000 by putting down $50,000 and borrowing $450,000. Let’s also assume the lender required that you pay private mortgage insurance (PMI) of 1% on the outstanding loan balance until the principal balance was reduced to $400,000. In this case, putting $50,000 towards the mortgage loan would eliminate PMI and save you $4,500 a year. This is a guaranteed, non-tax-adjusted return of approximately 9% exclusive of loan interest.
Other unique circumstances include loans with adjustable interest rates, loans that expose your assets to margin calls, student loan interest that would be discharged after being employed for a certain number of years or loans that would be entirely discharged in the event of your death. (For related reading, see: Student Loan Debt: What Ever Borrower Should Know.)
What Should You Do?
When done correctly, using leverage is a tremendous way to manage cash flow and build wealth. Many billionaires carry a mortgage and buy stock on margin. However, you need to do what makes you comfortable. If you know you have a low risk tolerance, sticking with the guaranteed returns of paying off all of your debt may help you sleep at night. If you are a risk taker that enjoys shooting for bigger, levered-up returns, than by all means, run the numbers and roll the dice.
Just remember that the tax code is complicated and just because something is deductible for one person doesn’t mean it will be deductible for another with different types of income and assets. Speak with a tax advisor before making any such decisions. (For related reading, see: The Hidden Costs of Hedge Funds.)