Q: I have debt I want to pay off, but I also want to start investing to enjoy the value of compounding. How should I think about household debt?
A: It’s probably never truly wrong to pay it off, but sometimes a little debt might not be a bad idea.
Let’s start with the easy part. Some types of debt should be attacked mercilessly with singular focus and attention until it’s gone. This would include any kind of payday loan, credit card debt, predatory car loans, or anything with a high interest rate. To me, a high interest rate is anything above what a reasonable investment portfolio could hope to produce on average in the future. Over the last 20 years, U.S. stock market returns have annualized about 10 percent a year and are unlikely to exceed that going forward, so any 10%+ interest rate should certainly be considered high these days and attacked with all available resources.
What about loans with lower interest rates? There’s still a good case to be made for paying them off as soon as possible. Even 0 percent interest sounds like a great deal, but it’s still money spent that you didn’t have at the time, and those payments impact your future financial security and flexibility until they’re gone.
There’s a lot of debate about what defines good debt. The most common example is a mortgage, as it represents a hybrid of paying for shelter and investment in the future. Real estate has made many people wealthy over the years, but not without risk. It’s hard to make big returns in real estate without borrowing, which works great most of the time, but can also go wrong, as we saw leading up to 2008. I believe in buying a house because you need a place to live, not as a speculative investment. Enjoy any appreciation, but don’t expect it and certainly don’t rely on it. A mortgage is usually the lowest-priority debt to pay off in a given household.
A case can be made against almost all other kinds of household debt. The problem is that virtually all household borrowing is financing consumption of things that are currently unaffordable. Some things might be necessary, like a reliable car, but a lot of unnecessary money is spent and justified in the name of reliable transportation. Generally, consumer loans like these should be minimized and paid off as soon as possible.
Student loans are a tricky subject, because right now, many people are expecting eventual forgiveness from the government. Forgiveness might come, or might not. Regardless of your expectations, it’s probably wise to avoid taking advantage of any kind of deferment where payments stop but interest continues to accrue.If possible, make payments so that the balance declines each month.
Credit scores are also tricky. On one hand, a decent credit score is necessary for basic tasks like renting apartments or opening bank accounts. On the other, I’ve seen many financially destructive things done in the name of establishing credit or building credit history. In my experience, credit history will naturally build up over time with things like car loans and a credit card with reasonable limits. There’s no reason to focus on gaming your score.
For some debt, it might make sense to keep the low-interest debt and invest any extra money in the markets. Keep in mind that we may not get another 20 years of 10 percent stock market returns, but there’s a good chance the market will outperform a 2.5 percent mortgage in the long term. Investing in things like 401(k) plans with an employer match should probably be prioritized even above paying off non-mortgage, low-interest debt. Ask your financial advisor about both opportunities and risks in your particular situation. It’s important to look at the big picture.
Many lives have been ruined by overwhelming debt, while I’ve never heard anyone complain about being debt-free, even if it’s not optimal. If in doubt, it’s probably never completely wrong to just pay your debts off if you can.
Have a question or topic you’d like to see covered in this column? Contact the author at ggard@telarrayadvisors.com. Gene Gard is Co-Chief-Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions.
