Achieving Double Digit Returns Can Be Pretty Easy
We should always be striving to get the best deal out of our money that we can. Sometimes this involves taking on more risk, but paying off debt is always risk-free.
For whatever reasons, many of us approach our savings and our debts separately, and often too separately. There are some situations where we may want to decide on treating them separately, if the advantages of setting aside certain amounts of money and saving it are greater than the advantages of paying off debt with this money, but very often this is not the case, and we do so anyway.
It’s not hard to imagine a situation where savings would be clearly preferable. If, for instance, we’re looking to decide between using a certain amount of money to pay down our low-rate mortgage or to put it in our retirement account, with our employer doubling our money, the average return being in itself higher, as well as the tax advantages that come with this saving it instead can indeed be the better choice.
On the other end of the scale, there are a lot of people who have money in a savings account, to be used for future needs, and also have high interest credit card debt. They are earning interest on this savings, around a single percentage, while they are paying 20% on the credit card balances.
That works out to a net opportunity loss per year of 19% on this money, and although this should make no sense when we stop to think, people aren’t really thinking very much when they do this. They may reason that they may need to use these savings, not realizing that they can access the funds just as easy from the cards.
If we have a credit limit of $20,000 on our cards and owe $10,000, and have $10,000 in a savings account, if we use the money to pay down this debt, if we need some or all of this $10,000 later, we can borrow it then. By not paying this down, we’re paying the interest on all this money now, instead of just on the portion we actually need when we need to borrow it down the road.
When we compare rates of return, we always want to compare it with what we may have gotten by putting our money into something else, in this case using it to pay down our debt instead of saving it. When we use our heads here, this means that the net return on our money when we save it is not the 1% but instead minus 19%, and therefore the relative return on paying off this debt is 19%.
Billionaire Mark Cuban Gets This
Billionaire Mark Cuban has spoken out on this recently, and unlike some billionaires, Cuban built his empire from scratch. Cuban is not by any means an expert in finance, he’s more of a regular guy who made a whole lot of money, but one does not usually make this much by acting too foolishly.
Cuban explains that “whatever interest rate you have – it might be a student loan with an interest rate of 7%, if you pay off that loan, you’re making 7%. And so that’s your immediate return, which is a lot safer than trying to pick a stock, or trying to pick real estate or whatever it may be.”
This does bring up a good point, and that’s we have to account for risk in making our investment decisions, and not all risk is equal. We might also expect a similar return from our investments, and 7% is right around the average for stocks over the history of U.S. stock markets, but within this is quite a bit of variability where we can be made to endure long periods in the negative as we wait for returns to revert to the mean.
Paying off debt is always risk-free though, because you are guaranteed to save the amount of interest you would have paid otherwise, and there is no risk at all of losing money at any time in the future from this decision.
Stocks can return more than this at times, and over the last 60 years or so the returns have been better, about twice the historical average over the last 100, which includes some pretty grim years in the first half of this period. Bear markets can last a long time though and we can go decades in between highs sometimes, and the prospects of having to sell when the market is down is a very real concern.
The higher the interest rate on the debt, the more appealing paying it off should be. The highest interest debt should always be paid off first, which might seem obvious, but there are plenty of people who pay more on their mortgage then they should at the expense of this higher interest debt, with pre-payments or more aggressive amortization periods.
This is another widely committed mistake, being too preoccupied with paying off your mortgage at the expense of carrying more higher interest debt than we should. It always needs to be primarily about getting the best return, and paying off low interest debt at the expense of higher interest debt does involve purposely seeking poorer returns on our money, like savings versus paying off debt so often does.
The type of debt that we are paying off matters as well though, meaning whether we are looking to pay off installment debt like loans and mortgages, or revolving debt such as that owed on credit cards and lines of credit.
With revolving debt, the payments can be recycled if needed, just like our paying off the $10,000 in credit card debt can. Provided that our borrowing power isn’t reduced, as it generally is not, we can freely use our savings to pay this down without worrying about this causing us to be short later.
We Also Need to Pay Attention to Future Needs
If, on the other hand, we use this $10,000 to pay off a car loan, an installment product, and use our savings that we had earmarked for future needs, and we don’t have revolving borrowing power to fall back on, we may be left without the means to access these funds if we need to.
This can leave us needing to apply for credit at a time where we may not qualify, and we may even have to borrow at much higher rates if we cannot borrow at more reasonable ones, or in some cases not be able to borrow at all. This also isn’t a timely approach, as it may take some time to get approved and to access the money we need, and we may need it today.
This does not mean that paying off the car loan here is necessarily a bad idea, but it does require that we have other arrangements in place to get the money we need if we do need some of this back in our pockets. This generally means looking at a line of credit if we don’t have one in order to cover this, and although credit card borrowing power may do as well, the higher rates is going to make this whole plan less appealing, especially if we see the need to borrow again as being likely.
The math involved is extremely simple, and we should always be looking to get the most out of our money and also do so in a way that provides us access to the money we may need when we need it. Savings isn’t the only game in town here though, and far from it, and taking a more sensible look at how we manage our money and what sort of real returns we get from it can definitely be something that can help us and our finances.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
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