There has never been a better time to pay off debt.
To be sure, the lenders are lined up at our mail boxes. They offer new credit cards, new mortgages, and new home equity loans— whatever. They do this because it is very profitable.
This is worth considering.
Perhaps Un-Borrowing would be a profitable activity for you and me. Maybe interest saved by not borrowing will provide a higher return than what we can get on our money by conventional saving and investing.
Indeed, I believe that is what the market is telling us.
Recall last week, when I demonstrated that the after-inflation, after-tax returns on money market funds, typical bonds, and average stocks were minus 3.15 percent, minus 0.9 percent, and a mere 2.4 percent, respectively. Well, let’s see how those returns stack up against what we can save by not having to pay interest on debt.
We’ll start with the big no-brainer: credit cards
According to bankrate.com, a site that tracks the returns for saving and the costs for borrowing, the average interest rate on fixed rate cards is now 12.72 percent, which is not deductible. You can, of course, get credit cards with lower rates if you’ve got a good credit score and do some hunting.
Adjust that return up for taxes and typical “convenience credit” costs 16.96 percent. Pay it off and that’s the effective return for you and me as borrowers. Even if you adjust it downward for inflation, it beats anything we can earn on our savings.
The story is the same with car loans. Pay off an average 5.91 percent car loan and you have a good “investment:” You’d have to earn more than 7.88 percent on your savings to offset the cost of borrowing.
If you happen to be one of the many homeowners whose itemized tax deductions aren’t deductible because they are less than the standard deduction, this is close to what your mortgage is costing you. You’d clearly be better off paying it down— and using your savings to do it.
And what about our All American favorite, the tax-deductible mortgaged home?
New 30 year mortgages currently cost about 5.65 percent. If the interest is tax-deductible and your interest deductions exceed the standard deduction, the effective cost of borrowing is 4.24 percent. Subtract 3.9 percent inflation (since you’ll pay the loan back with ever cheaper dollars) and borrowing only costs 0.34 percent.
It could be argued that borrowing for home mortgages is cheap. It compares well with money market funds or longer term fixed income investments. On the other hand, a net return of 0.34 percent (rate less tax savings) is still better than you’ll do in money market funds or most fixed income investments. So paying off mortgages whose interest is truly tax deductible is still a good idea.
If your mortgage interest isn’t tax deductible (because your itemized deductions are less than the standard deduction), paying it off is a great investment opportunity.
Comparing Real Returns and Real Costs:Why the Best “Investment” Is Debt Reduction |
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| These figures assume a 25 percent tax bracket for interest, 15 percent for equity returns, and a 3.9 percent inflation rate. Changes will affect the outcome. | ||||
| Investment or Debt | Rate | +/- Tax Adjustment | Less inflation adjustment | Net Cost or Return |
| Avg. Credit Card | 12.7% | +4.24% | (3.9%) | 13.06% |
| Avg. Car Loan | 5.9% | +1.97% | (3.9%) | 3.97% |
| Expected Stock Return | 7.4% | (1.10%) | (3.9%) | 2.40% |
| Avg. Home Mortgage (interest NOT deductible) | 5.6% | 0.0% | (3.9%) | 1.70% |
| Avg. Home Mortgage (interest deductible) | 5.6% | (1.40%) | (3.9%) | 0.30% |
| Fixed Income Investments | 4.0% | (1.0%) | (3.9%) | (0.9%) |
| Money Market Mutual Funds | 1.0% | (0.25%) | (3.9%) | (3.15%) |
| Sources: Ibbotson Associates, Bloomberg, Bankrate.com, author calculations | ||||
The bottom line here is very simple. If you’re carrying credit card debt at any interest rate while building low return investments, stop. Give paying off the credit card debt highest priority. The same goes for paying off anything but a zero percent car loan.
And if you live in an area of slow real estate appreciation, favor paying off your mortgage over building your fixed income investments.
On the web:
Scott Burns, Sunday, August 1, 2004, “Thinking Financial Blasphemy”:
http://www.dallasnews.com/sharedcontent/dws/bus/scottburns/columns/2004/stories/080104dnbusburns.4ba0c.html
For market rates on Treasury obligations:
http://www.bloomberg.com
For rates on Certificates of Deposit:
http://www.banxquote.com
For rates on consumer loans:
http://www.bankrate.com/brm/default.asp
For rates on low cost credit cards:
http://www.lowcards.com/
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
(c) Scott Burns, 2022