Nearly every day there are stories in the news about the growing credit card debt problem that plagues consumers throughout America. But what if you're one of the lucky ones that have disposable income, and you're trying to figure out what to do with the extra money?
In this article, we're going to explain a simple rule of thumb that can help families to figure out if they should invest their extra income or pay off some of their loans. As part of that discussion, we'll talk about risk adjusted returns and provide some examples that demonstrate the thought process people should go through before making this decision. Finally, we'll describe the benefits of creating an emergency fund.
Anyone that finds they're able to consistently save money each month has three practical options. They can begin to pay down any existing debt, invest the money in securities, or start building an emergency fund.
Admittedly, these last two options are quite similar; but as we'll soon explain, there is at least one important difference. Let's first figure out if it's better to save money or pay off some existing loans and credit card balances.
Paying off loans or credit card balances is really the same concept as investing money. Excess cash can be placed in a bank account and earn interest, or it can be invested in a mortgage. It doesn't matter if the money is placed in a certificate of deposit or a mutual fund. The money is being put to work somewhere.
Since that's true, there is one simple rule of thumb that can be used to make this decision:
Invest money where the risk-adjusted, after-tax, interest rate is the highest.
It isn't necessary to get into a deep discussion of asset performance against benchmarks, or learn how to calculate beta and alpha values to determine risk adjusted performance. It is important to understand one risk concept.
Anyone that thinks investing in the stock market or mutual funds is a guaranteed return of 10% is forgetting the market carries with it certain risks. While it's possible to gain 10% in the next year, it's also possible to lose money too. The greater returns associated with the stock market exist because of the risk investors are willing to take with their money.
This means that before investing excess cash in the stock market; it's important to realize these high returns come with significant risks too. That kind of investment might not be as good of a deal as it seems, and that's why the above rule of thumb contains the term "risk-adjusted."
It's also important to compare after-tax returns of any investment because income taxes represent real cash flow; it's money that truly leaves a household. For example, if someone can earn 2.0% on a money market account, the interest payments are taxable. Income taxes lower the effective interest rate paid by the bank.
On the other hand, let's say someone has a mortgage carrying an interest rate of 5.4%. Each payment made on the loan helps to pay down the balance, or principal, and some of the money goes toward interest charges. Since mortgage interest is tax deductible, the tax break lowers the effective financing charges paid on the loan.
The important concept to remember here is to compare after-tax interest rates.
After-tax interest rates are calculated using the following formula:
Interest Rate - (Interest Rate x Tax Rate) = After-Tax Interest Rate
If an investment provides a return of 10%, and the recipient is in the 25% federal income tax bracket, then the after tax interest rate would be:
10.0% - (10.0% x 25%) = 10.0% - 2.5% = 7.5%
The above calculations assume the interest rate being evaluated is either taxable or tax deductible. If not, then an adjustment is not necessary. Let's see how these concepts are put into practice using two examples.
In this first example, let's say Bill has a mortgage carrying an interest rate of 4.875%. Furthermore, let's say that a local bank is offering 5.60% on a one year certificate of deposit, or CD. Bill has an extra $1,000, so where should he invest for the next twelve months?
If Bill invested in the CD, then he'd have his original $1,000, plus $56.00 would have been paid in interest. This leaves him with $1,056.00 after 12 months. Let's assume he's in the 25% tax bracket. Bill would owe an additional $56.00 x 25%, or $14.00, in federal income taxes. His net gain on this investment is $42.00.
If Bill took that $1,000, and paid down his mortgage, that investment would have saved him $1,000 x 4.875% or $48.75 in interest charges. But those interest charges are tax deductible, so he lost a tax deduction of $48.75. This means Bill lost $48.75 x 25%, or $12.19, on his tax return. Bill's net gain on this investment is $36.56.
In this second example, let's keep the assumptions the same, except now Bill has the chance to pay off a $1,000 balance owed on his credit card at 16.0%.
If Bill invested in the CD, he'd still have a net gain of $42.00 as shown in the example above.
If Bill took that $1,000 and paid down his credit card balance, the investment would save him $1,000 x 16.0%, or $160.00, in interest charges over the next twelve months. In addition, credit card interest charges are not tax deductible, so the gain on that investment is not reduced. This means Bill's net gain is $160.00.
Generally, interest charges for student loans, first and second mortgages, and most home equity loans are deductible on a federal income tax return. The after-tax interest rate on these types of loans is usually very low.
But as this second example clearly demonstrates, paying down credit card debt usually provides the greatest rewards. Interest rates are usually relatively high, and the charges are not tax deductible. This kind of investment had two factors working in its favor.
At the start of this article, we mentioned there were three options. The third was to start building an emergency or "rainy day" fund. This idea goes back to one of the old "pay yourself first" concepts.
The first step most people take down the path to financial freedom is to create an emergency fund. This is money that is used for no other purpose other than helping to make it through a short-term financial hardship such as the loss of a job. Most emergency funds consist of four to six months worth of household expenses.
Because of the intended purpose of the fund, the money is usually placed in a relatively liquid investment such as a savings or money market account. Most of the time, the investor is going to give up something, such as higher returns on investment, in exchange for the convenience of owning an asset that can be quickly converted into cash.
The value of this fund is not the return it provides, but the peace of mind it brings to its owner.
About the Author - Invest or Pay Down Debt?