Perspective on Debt: Accepting Risk
In the first two parts of our series, we assumed that you had resolved to pay down some of your debt and were trying to come up with a strategy for doing so. In the introduction, we showed that having made that decision, the financial answer for the optimal strategy was relatively straightforward. In the second, we added the element of behavior, which significantly complicated the discussion.
This time, we're going to take away a different assumption. We'll still assume that you have some additional money available, but now let's consider that instead of automatically deciding to pay down debt, you are considering whether to pay down debt or whether to invest the money.
One simple way to start is to compare your potential investment returns with your list of effective interest rates while deciding where to allocate your additional money. While doing this, remember that your investment gains will have tax consequences that have to be factored in.
For example, if you have a choice between paying off a low-interest car loan at 1% versus purchasing a CD offering 1.5% and are the in 25% marginal income tax bracket, you’ll come out slightly ahead investing in the CD and using the proceeds to pay down the loan later. For $1,000, this would work out to about $6 (after taxes) after 5 years.
Where this becomes trickier is that there are very few opportunities to invest money with a guaranteed return better than any but the lowest rate loans. A more typical choice would be paying down a mortgage with a 4% interest rate versus adding to a diversified investment portfolio with a 6% average expected return.
The effective return advantage of the investment here is much greater than in the first example. Just to get a sense of scale, committing $1,000 to the same strategy as the first example would net you about $87 if the portfolio earned exactly 6% per year taxed as interest. (The actual tax picture of a realistic investment is more complicated in this case than in the first one, but that’s outside the scope of this article.)
A much more important difference, though, is that in this example, you don’t actually know your investment will return 6% per year. While a given investment strategy may end up averaging 6%, there’s a real risk that you could go months or years getting less than 6% or even losing money! You only know which decision would have been the “correct” decision had you made it at some time in the past. How do you approach a decision in this environment of uncertainty?
In general, if the interest on any of your debts is greater than the expected return of your investment choices, pay off the debt first. If you invest while keeping your debt outstanding, most outcomes are worse for you and you are accepting additional investment risk to boot. Most credit cards have interest rates higher than the reasonable expected return of any investment, which is why so much financial advice begins with paying off credit cards as soon as possible.
If your expected investment returns are greater than your debt interest, the choice is much less clear. The odds are tilted in your favor if you invest, but you introduce the chance that you’ll be worse off than if you had just paid down your debt. By itself, the difference between these two options is not going to make or break your life plans in most cases. To help come to a decision, ask yourself some questions: how comfortable are you holding debt? What’s your tolerance for investment risk? Have you actually experienced a significant investment loss before? How reliable is your income stream? What would it actually do to your life to have less money than you planned? What about more?
If you’ve worked with a good financial advisor before, you’ll probably recognize a lot of these questions; helping clients understand their attitudes towards risk and develop strategies to manage uncertainty is central to much of what financial advisors do. They can help quantify what the risks mean to your vision for your life and choose a strategy that gives you the best chance of realizing that vision. They can help set realistic expectations as well as offer guidance or reassurance when the unexpected occurs.
Uncertainty creates both analytical and emotional challenges, but it doesn’t have to be paralyzing. Knowing where you are trying to go and understanding your margin for error can help you stay on track despite the occasional bumps.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by FAI Wealth Management), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from FAI Wealth Management. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. FAI Wealth Management is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of FAI Wealth Management's current written disclosure statement discussing our advisory services and fees is available for review upon request.