Myth: It’s always better to pay down debt as fast as possible

This post is part of our financial myths series

 

You may have heard that it’s always better to pay down debt as fast as possible. There are two huge flaws with this advice.

Here are some factors to consider.

 

What do interest rates look like?

 

What if you were able to take out a loan at 2.5%? And, what if at the same time you were able to generate 5% on your investment portfolio? Does it make sense for you to take funds that could be in your investment portfolio and earning 5% to pay off the loan at 2.5%? Possibly not.

Considering things like mortgage interest deductions and barring any additional costs of carrying the loan, you will come out financially ahead by taking your time to pay down that 2.5% loan.

 

Money is extremely personal

 

Money and finances are extremely personal matters. Your money story and your history with money is different than anybody else’s. For some people, having any kind of debt induces anxiety. It doesn’t matter if they could pay off their debt 10 times over and there is little or no chance of having their home foreclosed upon, their car repossessed or having levies on their income, they just don’t like having debt. In these cases, it really may be the best thing for these people to pay down their debt as fast as possible. It’s very hard to put a price on personal contentment-or determine the cost of personal anxiety.

 

Risk tolerance

 

For some folks, there is a great deal of uncertainty about their financial situation. For instance, their income might be very variable – changing from month to month and year to year. Those folks are already tolerating risk in their variable income. They may not want to take on the additional responsibility of those principal and interest payments. In those cases, it might be helpful to pay down debt when the cash is flowing. That can help reduce fixed payments and make life a little easier during those low-income periods of time.

The same thing goes for those who are getting ready for retirement. If cash and income needs during retirement will be met easily, then it may make more sense to look at this question with strictly black-and-white benefit and cost numbers. In other words, if the return on investments is significantly higher than the cost of interest on the loan, it may make sense to pay off the loan slowly. Use those funds to get the higher return on investment. Use part of that return to pay the interest, and you still come out ahead.  On the other hand, if there is uncertainty about steady income during retirement, and especially if we are talking about the family home, you may want to have any indebtedness on the home paid off prior to retirement. Yes, there will still be ongoing expenses related to owning the home like upkeep and property taxes, but at least the monthly mortgage payments could be eliminated.

For the most part, we are talking about debt with fixed interest rates. There is additional risk if the interest rates are variable. Variable mortgage rates, credit card debt and lines of credit often come with variable interest rates. This means that while you may have felt that a monthly payment was reasonable when you took on the loan, and increased payment due to higher interest rates could be crippling. In those cases, the simple financial calculation showing costs and benefits needs to be balanced with the additional risk.

 

Using leverage

 

Remember, this is intended to be educational – not advice. In direct contrast to the notion that you should always pay down debt as quickly as possible, many successful investors actually take on debt just to build their investment portfolios. In other words, if they believe that they can get a better return on their investments than the cost of borrowing money to make those investments, they choose to incur the debt. They may do this even if they had cash readily available to make those investments. Because on the spreadsheet, with just black and white numbers, it shows a positive return. Again, this is just for educational purposes, not advice. These investors are taking on a serious amount of risk. They could lose their own money as well as borrowed money which they still have to pay back – with interest. But again, this strategy flies in the face of the notion that one should reduce their debt as quickly as possible.

I think the most important factor here is that money is very personal. Everyone handles money differently. Money affects different people differently psychologically. Some people get anxious having any kind of debt, while others look at it strictly as a tool to grow their wealth.

I think this is a prime example of making sure you are making informed decisions. Calculate the actual financial cost of carrying the debt versus any potential gain on the use of those funds. But ultimately, it comes down to how much risk you can tolerate and how comfortable you are holding that debt.

Myth: It’s always better to buy than rent

This post is part of our financial myths series

 

You may have heard that it’s always better to buy than rent. I would imagine that the thought behind this is that you are building equity when you buy. When you rent you’re just “throwing money away”.  Or when you rent you’re “paying someone else’s mortgage”.

 

Here are some factors to consider

 

What if you don’t know how long you’ll be staying in your present location? Try adding up closing costs for a new home and mortgage, possibly personal mortgage insurance, property taxes, as well as mortgage interest. Throw in the cost of any repairs or renovations. And now imagine having to pick up and move only two years later. Doing that over and over again is going to get mighty expensive.

An important consideration in the rent versus buy question is how long you think you will be staying in your home. When you spread all those costs over 10 years it’s not so bad. However, when you spread those costs over only two years it’s a different story.

 

Is an appropriate home available?

 

Rushing into the purchase of a home when there are no appropriate homes available is setting yourself up for grief. We are talking about what may be the largest purchase of your life. While your relocation may have been unplanned or even forced, that does not mean that you have to rush into purchasing a home. Renting in your new area for a period of time before settling on a particular neighborhood might be the best way to go. You’ll have the opportunity to learn more about your neighborhood, other nearby neighborhoods, and other pros and cons that are not easily observable when you’re just searching for a house.

 

What do interest rates look like?

 

If you just happen to be looking for a new home at a time when interest rates are sky high, it might make sense to rent for a period of time. Yes, if you purchase you can refinance in the future. But refinancing has its own costs. This goes back to how long you will be spreading those closing costs. Spreading the closing costs from purchasing your home over only a couple of years before refinancing means it was a very expensive couple of years. 

 

What homes are available for purchase?

 

What does the current inventory of available homes look like? Is there a home that fits your family’s current needs and future needs available right now at a reasonable price? Moving is expensive – both financially and emotionally. If you have young children, would you be willing to uproot them from their school when you find a better or more appropriate home in just a few years?

 

Real estate values don’t always go up

 

Barring any extenuating circumstances, real estate values generally go up over the long haul assuming that maintenance and upkeep are being done consistently. However, sometimes there are circumstances that are beyond your control. If you are the only ones keeping up your home in your neighborhood, your property value will probably decline in spite of your efforts. If a large industrial complex is built near your home, you may also find that your property value declines.  Sometimes regional economics are just not in your favor and property values decline.  Can you financially withstand a significant drop in property value?  If not, this may not be the right time in your financial journey to purchase a home.

 

Will you be house poor?

 

Do you have the financial resources to support the true cost of owning a home? While it may be true that you may be able to count on future raises and promotions which will free up some cash flow, that will take time. If your finances are very tight due to mortgage payments, property taxes, utilities, maintenance and upkeep, you could be very uncomfortable. In addition to these ongoing expenses, you would like to furnish your home. And, if all of your financial resources are going just to support your home you may become burnt out and resent owning that home.

 

A homeowner is taking on risk

 

When you own a home you are taking on risk. There is the risk that the market declines and you ultimately owe more on your mortgage then you can get by him selling your home. There’s the risk of damage to the physical house. Yes, there’s insurance.  But there’s also premiums, deductible and the hassle of dealing with repairs and replacements.

When you rent, you don’t have to take on the risk of the property value declining. If the neighborhood starts to change you can easily pick up and go elsewhere. If your career takes you to a different part of the world you can easily pick up and move.  And rather than being responsible for the entire structure, you’re only responsible for your own belongings (yes, you will need renter’s insurance).

There are many factors to consider when it comes to this question. As usual, the answer to this financial question is “it depends”. Regardless of your situation, you should never feel shamed into choosing to rent or to buy. It is a personal decision.  And making a decision based on “rules of thumb” or peer pressure could cause a lot of regret for you.  After all, those folks applying the peer pressure probably won’t be around to help if something goes wrong.

Myth: It’s always better to defer taxes

This post is part of our Financial Myths series

 

You may have heard that it’s always better to defer taxes.  And, on the surface, it seems reasonable.  Why should you give the government your money before you absolutely must?  You could be using that money.  And what about this tax drag you’ve heard about?  We want to avoid that, right?

 

Here are some factors to consider.

 

In a world of certainty, where you know that you could either pay $2500 in taxes today or you’ll have to pay the same amount in 10 years, it makes sense to defer the payment, especially if you have more productive uses for those funds.  But we don’t live in a world of certainty.  And, not only could things change before that tax comes due, for many households, it already doesn’t make sense to defer the taxes.

 

Lower tax bracket in retirement?

 

I suspect that this piece of wisdom came about when it was very likely that you would be in a lower tax bracket in retirement than during your working years.  Back then, there were so many tax brackets that it was likely that even a small decrease in income would put you in a lower marginal tax bracket.  In 1986 there were 15 U.S. federal income tax brackets.  Today, there are only 7 U.S. federal income tax brackets (if we don’t count estates and trusts).  Today, you could have a much larger decrease in income and remain in the same tax bracket.  So, it is quite possible that you won’t be in a lower tax bracket in retirement.

 

What about the tax brackets themselves?

 

And, tax brackets shift and change over time.  In fact, when considering U.S. Federal Income tax brackets, we are currently near historic lows.  Revisiting 1986 again, the top of the 25% tax bracket for Married Filing Jointly couples was $32,270.  In today’s dollars, that would be $87,387.  That means that a couple with more than $87,387 in taxable income would be in a marginal tax bracket of 25% or higher.  The highest tax bracket in 1986 was 50%!  Today, a Married Filing Jointly couple with $87,387 in taxable income would be in the 12% tax bracket and the highest federal income tax bracket is 37%.  And, in case you were thinking that I just chose an example of crazy high tax rates, in the late 1960s and 1970s, there were 25 tax brackets topping out at 70% and before that they topped out at 91%!  Therefore, you should consider the possibility that federal income tax rates rise again in the future.

 

What about “tax drag”?

 

Tax drag is how we describe the effect on your investments when your portfolio loses a percentage of its value each year to taxes – which then reduces the funds you have available to put to work for you for the subsequent years.  In a tax advantaged account where you defer the taxes until you withdraw the funds (presumably in retirement), you don’t have tax drag.  But, how much would your tax drag actually be in practice?  You don’t pay taxes on the value of your whole portfolio every year.  You only pay taxes on the income you actually realized – so for most people, only on the capital gains from selling an investment or perhaps distributions from stocks and funds and maybe interest.  You don’t pay income taxes on the rest of your portfolio that didn’t trade during the year.  If you are actively trading your retirement account, then, yes, you could generate significant taxable gains.  But if you aren’t actively trading, then the tax drag may have been minimal to start with.  And, the taxes paid on long term capital gains that you might generate from trading are relatively low – likely only 15% as compared to as much 24% or 32% on ordinary income in a regular taxable account.

 
Losing the benefit of capital gains tax rates

 

Which brings us to another factor to think about.  When you withdraw funds from a traditional IRA or qualified traditional 401k, 403b, or other traditional employer sponsored retirement account, you will be paying taxes at ordinary income tax rates regardless of the source of those funds.  In other words, if you contributed and deferred the taxes on $50,000 over your working years but due to market gains your retirement account is now worth $75,000, all of your withdrawals will be taxed as ordinary income – even though 1/3 of the amount was really capital gain. If those investments were in a regular taxable investment account the capital gain portion of the income would be taxed at the favorable capital gains rates.

 

Remember those REQUIRED minimum distributions

 

And the last thing I would like you to consider today is that you will be required to take distributions from your qualified retirement accounts in the future.  That means that you may be forced to take income, whether you need it or not, that pushes you into a higher tax bracket.  But, distributions from regular taxable investment accounts and Roth retirement accounts are not required.  To compound the tax effect due to forced distributions, your Medicare Part B premium is based on your taxable income and the percentage of your Social Security income subject to income tax is also based on your income.  So, not only could you be in a higher tax bracket due to the required distribution, you could also end up paying more for Medicare and subjecting more of your Social Security to taxes.

 

There’s the myth broken down.  Like most rules of thumb, it may apply to some people some of the time, but there are always exceptions.  In this case, the idea is outdated at best, and flat-out poor advice for many households