Rethinking Investing and Paying off Debts

the best path may have changed ….

Investing has changed as times have changed … financial planning rules need to change too

Old thinking

In the past, when asked by a client about adding principal payments to reduce mortgage debt, so that the mortgage would be paid off sooner, I advised them to invest that payment instead.  

That advice was based on the financial planning rule that you do not pay off debt when the after-tax cost of the debt is less than the after-tax return on the investments.  Instead, you use cash flow to add to the investment because this is how you increase your net worth – the total of all investments less all debt – over time. 

Also, by not paying down your mortgage quickly, you had the added benefit of not tying up working capital in your home.  You cannot sell a bedroom when you need funds for a child going to college. 

But that was then … things are different now ….

Changes

All components of the financial planning rule need to be reevaluated:  Interest rates and inflation are at or near historic lows.  The tax law on deduction of mortgage and other interest on debts has changed.  The disruption to the economy from the Pandemic has hurt businesses and that will affect future investment returns. 

Interest rates – With interest rates so low, the investment return on cash is near zero and the return on bonds is very low.  Rates are almost certain to rise, which will make bonds today worth less in the future (when low interest bonds compete against newer bonds that offer higher interest rates, they are re-priced to match the new rate and that decreases what anyone will pay for the old bonds). 

Tax deductions – The Tax Cut and Jobs Act made the standard deduction the option for more than two-thirds of taxpayers.  With the standard deduction, there is no benefit because the mortgage interest is not actually deducted to lower your net taxes due.  That means that the after-tax cost of mortgage debt is no better than the before-tax cost. 

Investment returns – to get a better sense of the likely investment returns for that side of the rule, I spoke to Hal Hallstein IV of the Sankala Group, LLC out of Boulder, CO.  He referred me to their post on Money Supply & Discount Rates, in which they discuss the impact of stimulus checks and PPP loans in an economy where recipients are likely to invest those funds or make financial purchases because simple consumption, travel and entertainment, has been shut down.  They also discuss the threshold return required for making an investment decision, viz. the discount rate.  In the post, he states:

But simultaneously, we also know buying bonds with zero yields won’t work for people’s retirements, which realistically require 3% yields. Where does this leave us?

He then presents a rationale for owning gold, an asset he has always avoided, as have I.  But now it serves as a protection against a downturn when you have a portfolio that invests primarily in the stock market. 

In our conversation, we compared the weighted cost of capital, the blended rate on all your debt, against the expected return from investing, which he pegs at 3.5 to 4.25% over the next decade, due to high equity valuations in the US and low interest rates.* 

One note of caution: to get those returns will require tolerating substantial volatility.

All of this leads to the following:  if your mortgage is at 3.5%, and you get no deduction value, and your potential return is 3.5% before taxes, on which you will have some tax hit, now or later, then paying off the debt is a better choice financially than adding to your investments.

New planning ideas

When you apply the debt to investment rule above, more people may find it best to pay down debt. 

For a mortgage, added to your monthly payment will have a substantial impact over time, cutting the total interest paid.  If you have a Roth IRA, it may even make sense to distribute funds to pay a student loan or car loan, depending on the loan interest rate.

There are still some reasons not to switch from retirement investing to debt reduction, such as when your employer offers a match for contributions.  For a good set of considerations to review before acting, see the Betterment 5-Step Action Plan.

Conclusion

While the planning rule used to lead to the conclusion that you are best off adding to investments rather than accelerating paying off long-term debt like a mortgage or car loan, the conclusion from applying that rule has flipped.  Many will increase their net worth by paying down debt sooner. 

I hope you and your loved ones are all managing this as well as you can during the Pandemic. 

Thank you, and be well

Steven

  * Sankala Group LLC’s communications should not be considered by any client or prospective client as a solicitation or recommendation to affect any transactions in securities. Any direct communication by Sankala Group LLC with a client or prospective client will be carried out by a representative that is either registered with or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. Sankala Group LLC does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented in this communication, or by any unaffiliated third party. All such information is provided solely for illustrative purposes.

Steven A. Branson, retirement, investing, Financial Strategies, debt, discount rate, decision making, newsletter, cost of capital

Investment advice on saving for retirement – now!

Start your investment plan – now! Your future portfolio will thank you

“There’s no time like the present”, especially when it comes to investing. Young adults have a great advantage over other investors: time.

Compounding – The benefit of time is that is allows for interest to compound, which is the ability of an investment to grow by reinvesting earnings. Consider that a single $10,000 investment at age 20 would grow to over $70,000 by the time the investor becomes 60 years old (based on a 5% interest rate). By comparison, the same investment made at age 30 would yield about $43,000 by age 60, and made at age 40 would yield only $26,000. The longer money is put to work, the more wealth it can generate in the future.

Matches – If your employer offers an employer-sponsored retirement plan, like a 401(k), we suggest you enroll in their plan. Not only is savings made easy through automatic payroll deductions, but your contributions are made with pre-tax dollars. Additionally, many employers offer 401(k) matches, which means they will contribute money into your account. If you don’t take advantage of this benefit, then you are leaving money on the table.

Resources – Another advantage young people have is there are now, more than ever, many low-cost services available to make saving and investing easy.

  • Consider the Acorns app. This app rounds up each transaction you make with your debit or credit card to the nearest dollar and invests the change into a diversified portfolio.
  • Robinhood is another useful resource. This app offers commission-free trading of listed stocks and ETFs. They run a lean company which allows them to operate for less. They make their money by accruing interested on investors uninvested cash balances and through fees charged in their upgraded version. This is a low-cost means of entering the investment world.
  • Check out Betterment.com, a robo-planner website for investing using ETFs that holds down fees. You use this to invest your taxable funds and your retirement plans, like IRAs.
  • Also check out earthfolio.com, a robo-planner for investing “with a social conscience.”

Whichever form of investment you decide to take, the earlier you begin, the better. Start building your wealth now! See also: Young people, don’t let this happen to you. Plan for retirement now!

 

[As we have stated in past posts, we recommend investing passively, using ETFs or index funds, so you save fees. You can buy a diverse set of ETFs, set up your portfolio and sleep until you rebalance next year.]

Passive vs. Active Portfolio Management

Choosing whether an active or passive strategy is right for your portfolio is an important and challenging decision and the answer may depend in the areas of the market in which you are investing. In more “efficient” markets, passive is traditionally preferred, but it is believed that active managers are able to outperform in areas like international-small cap stocks.
Morningstar recently took a look at all the mutual funds from its international small/mid-cap categories and found that these categories have many underperforming funds. In a review of Morningstar’s international small-cap growth, value and blend categories, analysts concluded investors would have less than a 50% chance of picking an outperforming fund. As Abby Woodham pointed out in her 6/20/14 article Passive vs. Active: Debating International Small Caps, “The average results are mediocre, but when we look at the list of funds that receive a Morningstar Analyst Rating, actively managed funds begin to look more attractive.”
While the funds on her list have provided significant alpha recently, they can be relatively expensive and their outperformance may waiver. And that leads to the challenge: even if active funds add value, they may not be consistent over time and, if you fail to catch them when this happens, your returns will lag passive funds. If you are concerned that the outperformance will not continue, but you want international small-cap value, an alternative may be a passively managed ETF.