No sooner did I publish my post, “Should I Buy CDs During A Stock Market Correction?” when a reader astutely raised another financial dilemma,
The challenge I encounter is the inability to resist the urge to pay extra toward my mortgage and student loans currently at 3.5% and 4%, respectively. I look at it as a 3.5% rate of return versus 2.5% on a CD.
As I’ve paid off both a rental mortgage and my MBA loans while concurrently investing in CDs and the stock market, let me share with you my thought process on how to solve this dilemma.
INVEST IN A CD OR PAY DOWN DEBT?
The first thing we need to understand is money used to invest in a CD, pay down a mortgage, or pay off student loans should be grouped together in one bucket: the guaranteed returns bucket. In a different bucket is the money used to invest in the stock market, private companies, and alternatives. This bucket carries risk in return for hopefully greater reward.
Within the first bucket of guaranteed returns, we can further differentiate between paying down debt and investing in a CD. Your mortgage and student loans will eventually be paid off based upon an agreed upon lending term. Even if you lob an extra $5,000 to pay down principal, your amortizing mortgage or student loan monthly payment will not change. The only thing that will change is your percentage mix that goes to paying principal (increases) and interest (decreases).
Given your mortgage and student loan payment amounts do not change, your monthly cash flow also does not change. The only real reason to pay down a loan quicker is due to the dislike of having such loans or the dislike of having loans plus the desire to make a guaranteed return compared to the risk alternative. You’ve already allocated some money towards riskier investments like the stock market.
The problem with paying down debt is that you increase your risk of insolvency because you reduce your liquidity. The increased risk might just move a hair, but it’s still moving towards insolvency if your income isn’t secure.
Here’s the game plan I followed to build my CD investment ladder for financial security while concurrently paying off $40,000 in graduate school loans in two years and a $464,000 mortgage in 12 years.
THE GAME PLAN
1) Secure and bolster your income as much as possible. The most important thing to have is strong cash flow. With strong cash flow, all financial worries tend to dissipate. Sooner or later, our debts are paid off even if we never pay down extra principal. Bolstering your income means doing a good job at work so you can get pay raises and promotions. Securing your income also means creating multiple income streams through dividend stocks, CDs, teaching, driving, rental property, online income and much more. Once your income streams are strong and diversified, you can make financial decisions from a position of strength.
2) Rank the guaranteed returns from highest to lowest. If you’ve decided to seek guaranteed returns, then allocating money to pay down the highest debt or investment return is most logical. Give each item a rank of between 1-5. You can also rank your debt amounts from most to least. But ranking the returns is only half the battle.
3) Rank the assets by desirability. Now that you have a clear picture of what costs or returns the most, you must rank each item by how meaningful the item is to you. For example, even though my Lake Tahoe property has a returns rank of 5 due to its highest 4.25% interest rate, the desirability of holding on to the asset is a 1 because it hasn’t been performing well. At one point, I was very tempted to let the asset go. Meanwhile, I might rank a 2.5% CD as a 2 for returns, but a 5 in terms of desirability for financial security. As a result, I would allocate more capital towards building a CD ladder over paying down my Lake Tahoe property. It’s up to each of you to decide.
4) Create timeframe goals for each investment. Goals make financial progress much easier to measure. Let’s say you take out a $500,000 30-year amortizing mortgage at a 3.625% interest rate, have $30,000 in student loan debt at 3% amortizing over 10 years, and a desire for financial security. You might want to set a goal to pay down your student loan debt within five years given it agitates you the most, come up with a plan to pay off the mortgage in 20 years, and build a $50,000 CD position in five years. I’ve found that attacking a smaller debt amount provides a greater sense of progress. Once you come up with your goals, you’ll naturally figure out a way to get there.
RECOMMENDED ORDER OF CAPITAL ALLOCATION
If you have all three, I recommend the following order for paying down or investing:
1) Student loans. Although student loan debt is at a record high, the average student loan is only about $32,000, a fraction of the average purchase mortgage size of $294,000 according to the Mortgage Banker’s Association in 2015. Paying down $32,000 in debt is much easier than paying down $294,000. Further, a student loan cannot be discharged/forgiven during bankruptcy. You can deduct the interest off of student loans up to $2,500, but only if you make under $80,000 as an individual or $160,000 as a couple. Check out SoFi to refinance your student loans.
2) CD ladder. Besides getting into the habit of maxing out your 401k, you should also build a CD ladder. The more rungs the better. Before you build a CD ladder, you should have at least six months of expenses, preferably in a higher yielding online savings account that is never touched. I recommend having 10% – 20% of your net worth in a CD ladder to provide priceless financial security as you strive to achieve your financial goals through risk investments and work.
3) Mortgage. Most mortgages are amortized (paid down) fully within 30 years even if you don’t pay extra principal. Until real estate accounts for less than 50% of your net worth, I don’t advise paying down extra principal quickly. Having too much of your net worth in an illiquid asset can spell trouble in a prolonged downturn. Mortgage interest indebtedness is deductible up to a $1M mortgage, and the mortgage interest deduction only starts phasing out after you make roughly $250,000 individually. Check out the latest mortgage rates with LendingTree. Mortgage rates have actually gone down since the Fed raised rates in December 2015. They have one of the largest network of mortgage lenders online who will compete for your business.
It should go without saying that nobody should ever carry credit card debt beyond the one month grace period. The average credit card debt is an egregious 15%, and often goes up to 30%. If you do have credit card debt, do everything possible to pay it off first and never get into revolving debt again.
GUARANTEED RETURNS VS RISK RETURNS
Some of you might wonder what percentage of your savings should be allocated towards Guaranteed Returns (CD, paying down debt) or Risk Returns (investing in the stock market, private equity, P2P, hedge funds). There’s no one size fits all guideline, but here are my suggestions.
Ages 18 – 35: 10% – 30% of savings to Guaranteed Returns, 90% – 70% of savings to Risk Returns. If you’re like most 20-something year olds, you’ve got student loan debt and potentially mortgage debt by the age of 35. Given you’ve still got your entire income earning life ahead of you, your chances of not being able to dig yourself out of a financial hole is smaller. As a result, you can stomach more risk to seek higher reward. Losing 50% of your investment as many people did in the 2008-2010 crash is not as big of a deal since your annual savings amount can make up a good portion of your portfolio’s losses.
Ages 36 – 50: 30% – 50% of savings to Guaranteed Returns. No longer can you just worry about yourself. You’ve now got to worry about a potential partner, your parents, your kids, and causes that matter most to you. Hopefully, you are in the highest earning time of your career where the absolute dollar amount going towards your Risk Returns is significantly larger than when you were younger. Your goal during this time frame is to at least eliminate your student debt and have zero credit card debt. With just an amortizing mortgage to pay off, you can pay down extra principal during times of excess liquidity or poor market environments.
Age 50+: 40% – 70% of savings to Guaranteed Returns. If you still have student loan debt and feel you haven’t made a dent in your mortgage by now, then it’s time to focus! You want to minimize your debt burden to coincide with a potential decline in income due to a layoff or impending retirement. Further, you need to have your risk-free assets built up to provide financial security. If you have no debt after turning 50, then you’ve already figured out how to live within your means and you should be free to allocate your savings to Risk Returns in a responsible manner.
Within the Risk Returns bucket, you can obviously adjust your allocation towards less riskier investments such as government bonds if you so choose. Below is another way to figure out what percentage of savings to allocate towards debt pay down or investing by the interest rate percentage.
The above guidelines work under the assumption that less debt is better than more debt and having a low guaranteed return on a risk-free asset like a CD is good enough once you’ve achieved a comfortable amount of wealth.
MANAGING LIQUIDITY IS KEY
At some point, your Risk Returns bucket will simply be bonus money that is no longer necessary to enjoy your life. Until that time comes I urge you to methodically allocate a portion of your savings towards the Guaranteed Returns bucket. Having too much of a financial safety net is better than having too little.
When I first graduated from college in 1999, I immediately began allocating 30% of my savings towards CDs, and the rest towards my 401K and after-tax investment account to one day buy a property. Work was rough, and the dotcom collapse was a huge wakeup call to hold risk-free assets.
After I bought my first place in 2003, I took out loans for my MBA between 2003-2006. During this time, I reduced my CD contributions to 20% of my savings and invested 80% into the stock market. Two years after I graduated, I paid off my student loans because it felt annoying and bonuses were still good back then. I couldn’t deduct any of the student loan interest and the stock market was beginning to turn. The feeling of paying off a significant debt was amazing.
From 2003 – 2013, I paid an extra $3,000 – $20,000 in mortgage principal each year when I felt I had excess liquidity and nowhere better to invest. After paying down an extra $140,000 in principal in 2014 using a mortgage arbitrage strategy, in 2015 I decided to pay off the remaining ~$100,000 balance. Locking in a guaranteed 3.375% return felt fine compared to an uncertain stock market.
Going forward, my plan is to attack my $418,000, 4.25% Lake Tahoe mortgage with $15,000 a year in extra principal payments. The goal is to pay the entire mortgage off in 11 years at the age of 50, 10 years earlier than the normal payoff schedule.
You can never lose if you lock in a gain. Just make sure to be aware of your liquidity at all times. The closer you are to achieving financial freedom, the more you should consider guaranteed returns.
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Updated for 2017 and beyond.