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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.
Related: How to Make Sense of Investing