Savings&Mortgage or No Savings&No Mortgage

[stormchaser]

How do you guys treat loan payments? I was talking to some investors and they were mixed on how they treated payments. Some said pay them off as quickly as possible and others said if you were sub 3.5% interest to pay the minimum plus a very small amount because investments will out pace the interest.

Certainly a valid point. However, there is more than meets the eye on this one.

The argument simply states that if I can make a higher return on an investment than the interest rate on my loan, then it's better to invest. Frankly, it's simple math...hard to argue. For example, for simplicity's sake, let's say I have a $100 loan from you at 3.5% interest. I pay you $100, but I still owe you $3.50 after that payment because you took interest out. The argument says, though, that my friend Billy will pay me a 4% return on my $100. So rather than pay off the loan, I invest with Billy and make $104! I take the $4, pay the $3.50 in interest to you, and make 50 cents by NOT paying off the loan! Add a few zeroes on to the end of those numbers here, and that's what this discussion is all about.

But just a word of caution for one important reason: taxes.

I understand that one can argue that taxes aren't paid until a sale of stocks, and I get that. But for the sake of this discussion, we are needing to compare at the end of the year whether it's best to have a loan or invest (the whole start of this thread). My investment has to do better than my loan for me to keep the loan, right? Well, we have to sell to pay that interest...and selling=taxes!

Ok, the problem is...oddly enough...math.

I would have to have a 4.375% annual return on my investment in order to simply EQUAL paying off my 3.5% loan!

If I had a $100,000 loan at 3.5% interest, I would pay $3500/year in interest. If I paid off the loan, I would make a guaranteed 3.5% return. GUARANTEED. (***Paying off a loan is making the equivalent return of the interest rate***). If I kept the loan, however, and invested, I would have to make 4.375% just to break even! $4375 profit at 20% in capital gains tax=$875. I pay the government $875, then take the amount left over which is you guessed it...$3500! I cover my loan and simply break even by having a higher return.

It's only AFTER 4.375% that I start making money, not 3.5%. You must consider this.

 

[SlumTodd_Millionaire]

Sorry, but that's incorrect math. The loan doesn't compound, while the investment does. If you have a car loan, for example, the amount of interest that you're paying over the length of the loan actually goes down as the balance goes down. By contrast, with your investment, the amount that you earn actually goes up with every successive year as the balance compounds. So, let's look at a 6-year car loan, since those seem to be all the rage nowadays, compared to investing with a 4% compounding annual return:

Car Loan
6-year term
3.5% interest rate
$30k principal
$3,304 interest over the term

Investment
6 year term
4% compounding return
$30k principal
$7,960 return

So, if I pay cash for the car, I save $3,304 over the 6 years. If I instead take out a loan on the car, and invest the $30k, at the end of the same six years, I will have experienced an investment return of $7,960, which is $4,656 more than the interest that would have been saved by paying cash for the car. Clearly, the much better option, and the difference was only 0.5% on the rate. A 4% return can be easily achieved with a very safe bond, so there isn't even a risk element that needs to be factored in. The necessary margin of safety is virtually non-existent.

"Compounding interest is the eighth wonder of the world." - Albert Einstein

But you mention taxes. So what will my taxes be on this, even if I do cash out at the end of 6 years? That's a long-term capital gains rate, so we're looking at 20%. That would total $1,592, which brings the investment return down to $6,368, still a very healthy margin over the interest paid.

 

[jtrain609]

When did the long term capital gain rate jump to 20%?

 

[SlumTodd_Millionaire]

When did the long term capital gain rate jump to 20%?

Depends on your tax bracket. Starting this year, if you're in the top bracket, you pay 20%.

 

[stormchaser]

Sorry, but that's incorrect math. The loan doesn't compound, while the investment does. If you have a car loan, for example, the amount of interest that you're paying over the length of the loan actually goes down as the balance goes down. By contrast, with your investment, the amount that you earn actually goes up with every successive year as the balance compounds. So, let's look at a 6-year car loan, since those seem to be all the rage nowadays, compared to investing with a 4% compounding annual return:

Car Loan
6-year term
3.5% interest rate
$30k principal
$3,304 interest over the term

Investment
6 year term
4% compounding return
$30k principal
$7,960 return

So, if I pay cash for the car, I save $3,304 over the 6 years. If I instead take out a loan on the car, and invest the $30k, at the end of the same six years, I will have experienced an investment return of $7,960, which is $4,656 more than the interest that would have been saved by paying cash for the car. Clearly, the much better option, and the difference was only 0.5% on the rate. A 4% return can be easily achieved with a very safe bond, so there isn't even a risk element that needs to be factored in. The necessary margin of safety is virtually non-existent.

"Compounding interest is the eighth wonder of the world." - Albert Einstein

But you mention taxes. So what will my taxes be on this, even if I do cash out at the end of 6 years? That's a long-term capital gains rate, so we're looking at 20%. That would total $1,592, which brings the investment return down to $6,368, still a very healthy margin over the interest paid.

Hmm...you set up an unfair comparison.

Scenario 1: $30,000 cash paid...then what? You sit on your butt? We have no loan expense, so money is piling up in my wallet!!!

Scenario 2: $30,000 invested AND monthly car payments throughout? Where did this car money come from? I understand that the car loan has to be paid each month...which is why I did it how I did. You are keeping the money in the bank the entire time for your compound interest and having a second source of income to cover the loan (unfair!). You can either take out the money from the investment to pay the loan (what I did and which tremendously hinders compound interest...of which I am fully aware), or bring Scenario 1 up to a level playing field.

If Scenario 2 gets $30,000 AND outside payments of $143.22 (the loan payments at 4%), then it's only fair that...

Scenario 1: $30,000 paid upfront and then $134.71/month (the loan payments at 3.5%) for SIX YEARS goes in a jar in the backyard...or better yet...invested.

Run those numbers, and get back to me.

Let's be fair here!

 

[SlumTodd_Millionaire]

A valid point, but I set up the scenario assuming that someone who is so stupid to pay $30k for a car up-front when 3.5% interest rates are available is also so stupid that he's going to blow his disposable income on something else rather than investing it for the 6 years.

If you assume that he's taking the disposable income and investing it every month without fail, then I agree with you. I find that incredibly unlikely, though, since someone who would do such a thing probably isn't very financially saavy. It's more likely that even if he does invest, it wil only be a portion of his disposable income, and will probably only be rarely, not every month.

Regardless, it all really comes back to the margin of safety principle. I don't think anyone is advocating what you suggest to start with: giving yourself less than a single percentage point between the interest rate and the expected investment return. Those of us who follow the Graham/Dodd/Buffett philosophy only invest when we have a significant margin of safety. For a 3.5% interest rate, I probably wouldn't be taking the loan unless I had an expected investment return of at least 6%. Of course, I do, so I would take the loan without hesitation. But if you're someone incredibly risk-averse, and you only put your money in investment grade bonds or treasuries, then you're better paying cash for the car. And I would also suggest growing a pair and stop being so risk-averse.

 

[Tommay85]

I had a bit of debt racked up from college, consumer debt and a car loan. Had a great paying job soon after and paid off everything in six months and pocketed/invested the rest(the Ramseyish approach). Looking back, paying it off over a longer period of time and investing more would have been better. Specifically, I missed out on the Ford Motor Co stock shenanigans in 2009/2010 because I was so obsessed with paying off debt. To someone that doesn't know the car industry, that probably looked risky, but the writing was on the wall that it was going to explode, and it did. Now, I wasn't going to put ALL my money on it, but instead of 100ish dollars, I could have probably thrown 1000 at it. That growth would have eclipsed my debt interest so much, I can't even laugh at it. I cry a little thinking about it actually.

I will butt heads with ATN all day long about some things, but debt management>debt free.

Regarding cars, they're a crap shoot. It's a product that you buy, use, and throw away(it pains me to say this as a car guy) You're going to eat the depreciation(which makes interest look non-existent) regardless, and/or if you go old enough, fixing it all the time. At any rate, I've yet to hear a non-emotional based argument for doing one purchasing method over the other, cash/lease/make payments. What's best is pretty much dependent on your financial situation only. In my current situation, if I HAD to buy a new car tomorrow, paying cash would pretty much wipe out 1/4 to half of my savings and investments. Is that a good idea? My gut/limited intuition says no.

 

[fly22]

Those who can, do.
Those who can't, teach.