Tuesday, October 12, 2010

The Payoff for Paying Off Debt.

Should you pay off debt or borrow money and invest?  Turns out to be a tricky question!

The following is a thought experiment on the merits of paying off debt versus savings.  As I have noted before, our tax code encourages us all to take on mortgage debt and then save to tax-deferred savings plans.  Is using the tax code as an investment guide a good idea?  I am not sure...  The following is only a thought experiment!

Suppose you could be debt-free.  Just suppose for a moment.

What would be the payoff?

Pundits and financial gurus say it is "OK" to be in debt.

But is it?  What is the advantage to being debt-free?

A Hypothetical Example:

Take Joe.  He's a typical American, living the Washington DC area making $100,000 a year.  He has $250,000 in mortgage debt at 6.5%, and $25,000 in car loans at 8% and a shameful $20,000 in credit card debt at 14%.

He pays about $1600 a month in the mortgage payment, most of which is initially interest.  He will, over the life of the loan, pay $318,000 in interest.

The car loan has a monthly payment of $610, and over the life of the loan, he will pay $4200 in interest payments.

The credit cards have a monthly payment of $310 a month (minimum) and will take 10 years to pay off at that rate.  If he does, he will pay an astounding $17,250 in interest - nearly double the amount charged.

Combined, he is paying $2520 a month in payments to lenders, or about 1/3 his income at $100,000. Given that another 1/3 easily goes to taxes, he is spending half his take-home pay on monthly payments to lenders.  And a big chunk of that is interest.  And of the remaining balance (about $30,000 a year) he has pledged to put $10,000 into his 401(k).  This leaves him, about $400 a week to buy groceries, clothing, entertainment, utility bills, appliances, etc. or perhaps save for his children's education, if he decides to have any.  He does not have a lot of disposable income!

He also puts aside $10,000 a year into his 401(k) plan to save for retirement.  With all this bills and his lifestyle, it seems he never "gets ahead" on his debts - barely able to pay more than the minimum on his credit card bills.  And when one car is "paid for", it breaks down, so he buys a new car and gets on the loan bandwagon all over again.

Over a period of 30 years, he will save $300,000 in his 401(k) account, which if it returns a 5% annual rate of return, will be worth nearly $700,000 when he retires.  If he continues on this plan, pays off his home, he will have a net worth of over a million dollars by the time he retires.  That is a big "IF" of course - hoping that the market won't tank and drop the investment value in half - or down to zero, if he invested in GM stock.  And assuming you will make a consistent 5% is also speculative.  There is risk in this scenario - definite risk.

Suppose he decides instead, to pay down the debt on his home instead?  If he paid $10,000 additional every year on his mortgage, he'd pay off his home in 13 years, and total interest paid is $112,000, or less than half what he would have paid before.  For the remaining 17 years (30-13) he puts $10,000 plus the $1600 a month into savings for a total of $29,200 a year.  At 5% rate of return, he ends up with $792,000 in the bank at the end of a 30 year period, plus his home is paid for.  In this scenario, he ends up with $100,000 more in the bank ($792,000 versus $700,000).

Interesting.   The approach most people take is full of risk.  If the market goes down - like it did last year - he could lose a lot of value in his portfolio.  If the housing market goes down - like it did last year - he has little equity in his home and could be "upside down" on his mortgage.  And if the job market goes down - like it did last year - he could end up with no source for the perpetual payments that are needed to keep the whole enterprise afloat for even a nanosecond.

On the other hand, if he put his money toward paying down debt, he might actually have equity in his home in a few short years - even if the market goes down.  In 13 years, he would own it outright, and regardless of market values, could "cash out" on it if he needed money.  Moreover, he would not need the "cash flow" of the monthly mortgage payments, so if he lost his job, he could afford to live longer without having to sell (or worse yet, walk away from) his home.

In other words, the debt-free approach is more robust in difficult market conditions, and safer as well.  While housing prices can drop in half in volatile markets, they do bounce back over time.  Things like GM stock, on the other hand, goes down to zero and stays there forever.

Tax Effects:

Of course, if the entire transaction were "tax neutral" it clearly would be a better idea to pay off debt than to save and more slowly pay off debt over time.

But that is the rub.  Our tax code has become our investment manual - and we are pressured to take advantage of these middle-class "gimmies" by investing in IRA and 401(k) plans and borrowing money instead of paying cash.

By putting $10,000 a year into his 401(k), he saves roughly $3,000 a year on his taxes or about $100,000 over 30 years.  Similarly, by paying $1600 a month on the mortgage payment he saves roughly $6000 a year on his taxes - for the first year at least - the value declines over time.  So in terms of tax savings, he comes out ahead by $9000 per year, the first year, or about the amount he put in the 401(k) plan.  But over the life of the mortgage, paid over 30 years, he will paid about $300,000 in interest and have roughly $100,000 in tax savings (they decline as the mortgage balance declines and interest is a smaller and smaller part of the loan).   So all told, he saves about $200,000 over 30 years in taxes.

Taking the second approach, and paying the extra $10,000 toward the mortgage balance instead, he gets only $30,000 in tax deductions from the mortgage, paid in full after 13 years.  But he may be able to save about $170,000 in taxes if he can contribute $29,200 per year for those last 17 years (Note:  This may exceed the allowable deduction for him alone, but he could put it in his wife's name if their income is joint, and/or into an IRA, and after age 50, he can put in "catch up" amounts as well, so it may be feasible).

So, method #1, $200,000 in tax savings, biased toward the early earning years (when income is lower), method #2, $200,000 in tax savings, biased more toward the later earning years (when income is higher).   Whoa, am I missing something here?  It is pretty much a wash yet again?

In the second scenario, he is putting far more cash into his IRA/401(k) and thus at least on the surface, the amount of deductions may actually increase - there are, however, caps on how much you can contribute.  In the first scenario, he is taking advantage more of the beauty of compound interest to build his portfolio - but also gambling on it more.

I am not sure which is a better solution.  I am just playing with some numbers here.  The big thing the numbers DON'T take into account is level of risk exposure.  While the "Deduct your way to wealth" scheme may look better on paper (and from what I am seeing, it may be better, but not by an astounding lot!) it does not factor in the risk factors.  Investing in stocks is far riskier than paying off your debts.

I think there is no clear answer here, although I lean toward the debt-free side.  Stocks and Mutual funds are opaque instruments, and often you are buying a pig in a poke.  My own home, paid for, however, is something quite concrete (sometimes literally) and I have a firsthand feel for the local market values and pricing and underlying worth.  I do not need an annual statement to understand how much my home is worth - I need only see what the neighbor's house sells for last week.

I am going through these gyrations because I am on the cusp of being debt-free next month - if everything works out (knock wood) and I want to understand completely which is the best option - pay off debt, and then invest income?  Or invest money and slowly pay off debt.  The former is also "safer" in terms of possible job loss, income loss, reduced income in retirement, illness, etc.

Using the Tax Code as your Investment Guide:

  • Better Tax Deductions - perhaps
  • More money saved over time - perhaps
  • More money saved earlier - take advantage of compound interest
  • Requires high monthly cash flow
  • Less safety net if income is reduced or in the event of job loss
  • More likely to be "upside down" or have little equity in home
  • Stock market is far riskier investment

Paying Down Debts First:

  • Security - pay down debt, built equity in home - less chance of being "upside down"
  • Same money saved over time - if calculated from a tax-neutral position
  • Flexibility in case of job loss or income decreasing - no need for high cash flow

  • Higher taxes during early years (but these are lower earning years as well!)
  • If income drops in later years, there is no way to save for retirement
  • Doesn't take advantage of market and compound interest (but has less risk, too).

I am still not sure what is the correct answer here.  Perhaps a hybrid approach is what works best - and what a lot of people end up using.

And I did not address Joe's staggering credit card debt and car loan debt.  The monthly payment of those two debts would be more than enough to either fund his 401(k) by $10,000 a year OR pay down his mortgage payment by $10,000 a year.  The "opportunity cost" of having consumer debt is very dear - and perhaps that is the one lesson we CAN draw from this.

I have an opportunity to be debt-free.  Should I do it?  Or maintain my debts and "invest" the money in the market and try to make more there, faster than I am paying interest in my debts?

I think for my age (50) paying off debt is the better approach.  While I could have afforded to take such a risk at age 30, it is harder at age 50 to recover from market setbacks, and gambling it all on what are very, very opaque investments, could be disastrous.

In addition, I would like to have the flexibility to be able to retire earlier, or to respond to changes in the market or job situation.  Many Patent Attorneys are starving these days, and having to maintain the high-wire balance act of the high income - and high monthly payments, gets to be old after a while.

But it is interesting to "crank the numbers" on this.  Obviously my math here is coarse, and may have some errors in it (please feel free to point them out).

But if the numbers are not too far off, the vaunted "savings" in going into debt for a mortgage to get a tax deduction and then saving in a 401(k) to get another tax deduction may be ephemeral.  Paying down debt and then saving once debt is cleared might be safer solution that ends up creating the same or a similar amount of wealth in the long run - with far less risk involved.

Just a thought.    Now, to crank some actual numbers for my personal situation.

UPDATE 2021:  Turns out, it depends on what part of life you are living.  At age 61, I am debt-free, but live on $30,000 taxable income a year, which means pay no taxes (to speak of) and deductions are a fantasy.  Moreover, I qualify for an Obamacare subsidy (nearly 100%) by keeping my "taxable income" low.  If I had debt, I would be paying thousands more in taxes and lose my Obamacare subsidy and be in a very risky position.  Maybe debt makes sense when you are young - to buy that first house or to get a worthwhile education.  But as you age, I think the goal should be to be debt-free.  We are born without debt, and should die the same way.