Should You Pay Down Debt or Invest Idle Cash?
When you have a large cash reserve, should you take that opportunity to pay down debt or should you invest it? The answer is “it depends”. It depends on:
What is the interest rate on your debt?
What is the funding level of your emergency fund?
Do you have any big one-time expenses planned within the next 12 months?
What is the status of your financial goals? (college savings, retirement, house purchase)
How close are you to retirement?
What type of economic environment are you in?
Understanding the debt secret of the super wealthy
All too often, we see people make the mistake of investing money that they should be using to pay down debt, and this statement is coming from an investment advisor. In this article, I am going to walk you through the conversation that we have with our clients when trying to determine the best use of their idle cash.
What Is The Interest Rate On Your Debt?
Our first question is typically, what is the current interest rate on your debt? As you would expect, the higher the interest rate, the higher the payoff priority. As financial planners, we look at the interest rate on debt as a risk-free rate of return, similar to a return that you might receive on a bank CD or a money market account. If you have a credit card with a balance of $10,000 and the interest rate is 15%, you are paying that credit card company $1,500 in interest each year. If you use your $10,000 in idle cash to payoff you credit card balance, you get to keep that $1,500. We considered it a “risk-free” rate of return because you don’t have to take any risk to obtain it. By paying off the balance, you are guaranteed to not have to pay the credit card company that $1,500 in interest.
If instead you decided to invest that money, you would have to invest in something that earns over a 15% annual rate of return to be ahead of the game. To obtain a 15% rate of return is most likely going to involve taking a high level of risk, meaning you could lose some or all of your $10,000 investment so it’s not an apple to apple comparison because the risk level is different. I will bluntly ask clients: “can you get a bank CD right now that pays you 15%?” When they say “no way”, then I repeat the guidance to pay down the debt because every dollar that you pay toward the debt is receiving a 15% rate of return which you are not paying to the credit card company.
A Tough Decision
A 15% interest rate on debt makes the decision pretty easy but what happens when we are talking about a mortgage that carries a 3% interest rate. Clearly a more difficult decision. Someone who is 40 years old, that has 25 years until retirement might ask, “why would I use my cash to pay down the mortgage with a 3% interest rate when I could be earning 8% per year plus in the stock market over the next 25 years?” The answer can be found in the rest of the variables below.
Emergency Fund
When unexpected events happen in life, it is common for those unexpected events to cost money, which is why we encourage our clients to maintain an emergency fund. Maintaining an adequate cash reserve prevents these unexpected financial events from disrupting your plans for retirement, paying for college, from having to liquidate investments at an inopportune time in the market, or worse to go into debt to pay those expenses. While it is painful to see cash sitting there in a savings account earning minimal interest, it serves the purpose of insulting your overall financial plan from setbacks cause by unplanned events which in turn increases your probability of achieving your financial goals over the long term.
What is the right level of cash to fund an emergency fund? In most cases, we recommend 4 to 5 months of your living expenses. There is a balance between having adequate cash reserves and holding too much cash. There is an opportunity cost associated with holding too much cash. By holding cash earning less than 1% in interest, you may be giving up the opportunity to earn a higher return on that cash, whether that involves investing it or paying down debt with it.
Here is a common scenario, let’s say someone has $50,000 in cash in their savings account, and 4 months of living expenses is $30,000, that means there is $20,000 in excess cash that could be potentially earning a higher return than it sitting in their bank account. If they are willing to accept some risk, they may be willing to invest that $20,000 in an attempt to generate a higher return on that idle cash, or the cash may be used to fund a college savings account or retirement account which could carry tax benefits as well as advancing one or more of their personal financial goals.
But what if you don’t want to take any risk with that additional $20,000? If you have a mortgage with a 3% interest rate, by applying that $20,000 toward the mortgage, it is technically earning 3% because you are not paying that 3% interest to the bank. Since the interest rate on the mortgage is probably higher than the interest rate you are receiving in your savings account, that cash is working harder for you, and you have the added benefit of paying off your mortgage sooner.
Big One-Time Expenses
Once we have determined the appropriate funding level of a client’s emergency fund and there is excess cash over and above that amount, our next question is “do you have any larger one-time expenses that you foresee over the next 12 months?” For example, you may be planning a kitchen renovation, purchase of a house, or tuition payments for a child. If you will need that excess cash to meet expenses within the next 12 months, you may want to just hold onto the cash. If you use the cash to pay down debt, you won’t have the cash to meet those anticipated expenses in the future, or if you invest the cash, and the value of the investment drops, you may not have time to wait for the investment to recover the lost value before you need to liquidate the investment.
Typically, when we talk about investing, whether it’s in stocks, bonds, mutual funds, or some other type of security, it involves taking more risk than just sitting in cash. The shorter the timeline on the one-time expense, the more risk you take on by investing the cash. Historically, riskier asset classes like stocks behave in more consistent patterns over 10+ year time periods, but it’s impossible to predict how a specific stock or even a bond mutual fund will perform over a specific 3 month period.
Now, if interest rates ever get higher again, and you can find a 6 month or 1 year CD, or money market that pays a decent interest rate, then you may consider allocating some of that short term excess to work in a guaranteed security. Be careful of products liked fixed annuities, even through they may carry an attractive guaranteed interest rate, many annuities have surrender fees if you cash in the annuity prior to a specified number of years.
Status Of Your Various Financial Goals
Our next series of question revolves around assessing the status of a client’s various financial goals:
When do you plan to retire? Are your retirement savings adequate?
Do you have children that will be attending college? Have you started college savings accounts?
You just bought a house. Do you have an adequate amount of term life insurance?
Do you expect to be in a higher tax bracket this year? We may need to find ways to reduce your taxes.
Do you have estate documents in place like wills, health proxies, and a power of attorney?
What are your various financial goals over the next 10 years?
If we find that there is a shortfall in one of these areas, we may advise clients to use their excess cash to shore up a weakness in their overall financial picture. For example, if we meet with a client that has 3 children, ages 8, 5, and 3, and we ask them if they plan to help their children to pay for college, and they say “yes” but they have not yet determined how much financial aid they may receive, how much college is going to cost, and the best type of account to save money in to meet that goal, we will probably run projections for them, discuss how 529 accounts work, and potentially allocate some of their excess cash to fund those accounts.
How Close Are You To Retirement?
One factor that normally weighs heavily on our guidance as to whether someone should use excess cash to pay down debt or invest it is how close they are to retirement. Regardless of the market environment that we are in, we typically encourage our clients to reduce their fixed expenses as much as possible leading up to retirement. But when the stock market is going up by 10%+ and someone has $50,000 left on a mortgage with a 3% interest rate, they will ask me, why would I use my excess cash to pay down debt with a 3% interest rate when I’m earning a lot more keeping it invested in the market?
My response. I have been doing retirement projections for a very long time and when we do these projections, we are making assumptions about:
Annual rates of return on your investments
Inflation rates
Tax rates in the future
The fate of a broken social security system
How long you are going to live?
Probability of a long-term care event
These assumptions are estimated guesses based on historical data but who’s to say they are going to be right. In retirement you don’t have control over the stock market, inflation, or unexpected health events. The only thing you have full control over in retirement is how much you spend. The lower your annual expenses are, the more flexibility you will have within your plan, should one or more of the assumptions in your plan fall short of expectations. There will always be recessions but recessions are a lot more scary when you are retired and drawing money out of your retirement account, while at the same time your accounts may be losing value due to a drop in the stock or bond market. If you have lower expenses, it may allow you to reduce the distributions from your retirement accounts while you are waiting for the market to recover, which could greatly reduce the risk of running out of assets in retirement.
Type of Market Environment
While no one has a crystal ball, there are definitely market environments that we as investment advisors view as more risky than others. When economic data is providing us with mixed signals, there are geopolitical events unfolding that we have no way of predicting the outcome, or we are navigating through a challenging economic environment, it increases the risk level of investing excess cash in an effort to generate a return greater than the interest rate that someone may be paying on an outstanding debt. We definitely take that into account when advising clients whether to invest their cash or to use it to pay down debt.
The Debt Secret of The Super Wealthy
I have recognized a trend as it pertains to high net worth individual and how they invest, which is a concept that can be applied at any level of wealth. Having less debt, can provide individuals with the opportunity to take greater risk, which in turn can lead to a faster and greater accumulation of wealth.
If someone has no debt and they have $90,000 in cash to invest, because they have no debt, they may not need any of that cash to meet their future expense. Assuming they have a high tolerance for risk, they may choose to invest in 3 start-up companies, $30,000 each. Since investing in start-ups is known to be very risky, all three companies could go bankrupt. If 2 companies go bust, but the third company gets acquired by a public company that results in a 10x return on the investment, that $30,000 initial investment grows to $300,000, which subsidizes the losses from the other 2 companies, and still generates a giant return for the investor.
Someone with debt and corresponding higher fixed expenses to service the debt, may find it difficult and even unwise to enter into a similar investment strategy, because if they lose all or a portion of their $90,000 initial investment, it could upend their entire financial picture.
Just an additional note, investors that are successful with these higher risk strategies do not blindly throw money around at high risk investments. They do their homework but having no debt provides them with the opportunity to adopt investment strategies that may be out of reach of the average investor.
In summary, there are situation where it will make sense to invest idle cash in lieu if paying down debt but there are also situations that may not be as obvious, where it makes to pay down debt instead of investing the idle cash. Before just playing the interest rate game, it’s important to weigh all of these factors before making the decision as to the best use of your idle cash.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
