Decision on wiki: Paying Loans vs. Investing

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assumer
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Decision on wiki: Paying Loans vs. Investing

Post by assumer »

This topic is specific to this section of the wiki page Paying Down Loans vs. Investing:
If the decision is close: If the decision is close, it is likely to be better to keep the loan. One reason is that you can refinance your loan if interest rates fall, so the effective cost of the loan to you could be slightly less than it's interest rate. For comparison, the Treasury cannot refinance its bonds so it can not take advantage of lower rates. Most municipal bonds have only limited call provisions. In addition, if the choice is between investing in a 401(k) or IRA and paying down the loan, investing in the 401(k) or IRA will give you more tax-deferred investments, which will remain valuable even after you have paid off the loan.
Link to discussion.

I was going to change that section because I didn't necessarily think that paying down loans should be forgone for purchasing bonds when the decision is close, but I wanted to come to a consensus on here before doing anything. My original thought was that getting yourself out of debt is most of the time the best decision because it reduces your risk, is a guaranteed, tax-free investment, in addition to psychological factors.

The reason as far as I can gather, for purchasing bonds, if the decision is close, could be illustrated in the following example:

If the rates are close, there may still be an advantage in keeping the loan due to changing rates. Let's assume you have $10,000 to either pay down a 5% loan, or invest in a 5% treasury bond. If rates fall to 2% next year, for example, and you had paid off the loan, you are stuck buying treasury bonds at 2% in the future. However, if you had bought treasury bonds, then you may be able to refinance your 5% loan at 2%, and are also holding a 5% treasury bond.

Is my example above correct? What do others think is the best way to present the information?

Also can others explain the muni-bonds and call-provisions?

Let's try to keep the discussion focused on just that aspect of paying loans vs. investing and how it relates to the best way to present it on the wiki, not necessarily the topic in general, please.

Mods can move this to another forum if that's more appropriate.
bdpb
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Re: Decision on wiki: Paying Loans vs. Investing

Post by bdpb »

assumer wrote: The reason as far as I can gather, for purchasing bonds, if the decision is close, could be illustrated in the following example:

If the rates are close, there may still be an advantage in keeping the loan due to changing rates. Let's assume you have $10,000 to either pay down a 5% loan, or invest in a 5% treasury bond. If rates fall to 2% next year, for example, and you had paid off the loan, you are stuck buying treasury bonds at 2% in the future. However, if you had bought treasury bonds, then you may be able to refinance your 5% loan at 2%, and are also holding a 5% treasury bond.
Interest rate moves are not a one way street. They can go up just as well as go down. You need to compare an example for both cases.
RobInCT
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Re: Decision on wiki: Paying Loans vs. Investing

Post by RobInCT »

Not totally responsive to the question you are asking, but just wanted to point out that under current rules, student loans--a big portion of many people's total debt--generally cannot be refinanced. Consider adding a modifier specifying that the analysis for the close case is primarily for mortgage debt.
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assumer
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Re: Decision on wiki: Paying Loans vs. Investing

Post by assumer »

bdpb wrote:
assumer wrote: The reason as far as I can gather, for purchasing bonds, if the decision is close, could be illustrated in the following example:

If the rates are close, there may still be an advantage in keeping the loan due to changing rates. Let's assume you have $10,000 to either pay down a 5% loan, or invest in a 5% treasury bond. If rates fall to 2% next year, for example, and you had paid off the loan, you are stuck buying treasury bonds at 2% in the future. However, if you had bought treasury bonds, then you may be able to refinance your 5% loan at 2%, and are also holding a 5% treasury bond.
Interest rate moves are not a one way street. They can go up just as well as go down. You need to compare an example for both cases.
Okay so if interest rates move up to 7%:
Option 1: You paid off the loan. Next year you buy bonds at 7%.
Option 2: You bought treasury bonds. Next year you have a relatively-low-interest loan and also buy bonds at 7%.

In either case, do the considerations cancel out when interest rates move up, since nobody in their right mind would refinance a loan to a higher interest rate? It seems that if interest rates go up, then the refinancing point is moot. Is this correct? If so, this can also be added to the wiki for comparative purposes.
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JamesSFO
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Re: Decision on wiki: Paying Loans vs. Investing

Post by JamesSFO »

There is also the opportunity cost/flexibility type analysis. In the close case, holding the cash in a fairly safe investment (EE Bonds, I bonds, short duration/low EWD penalty CDs) gives you flexibility. Once you pay down the debt it may be hard to reopen a line of credit, etc.

The flip side is paying off debts and owning things outright can provide a level of peace of mind.

I think a fair generalization is that particularly in a low interest rate environment the financial choices can also be traded against secondary flexibility and emotional factors.
bdpb
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Re: Decision on wiki: Paying Loans vs. Investing

Post by bdpb »

assumer wrote:
Option 2: You bought treasury bonds. Next year you have a relatively-low-interest loan and also buy bonds at 7%.
The value of the bonds you bought are now worth less.
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assumer
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Re: Decision on wiki: Paying Loans vs. Investing

Post by assumer »

All good points. Do others have a suggestion for the best way this could be presented on the wiki?
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JamesSFO
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Re: Decision on wiki: Paying Loans vs. Investing

Post by JamesSFO »

assumer wrote:All good points. Do others have a suggestion for the best way this could be presented on the wiki?
Given that the totality of the page covers many of these issues why not frame it as "If by the numbers the decision is close, ..." that reminds people to start with the math rather than the emotions. Then use the text you offered and remind people that "For close decisions, the non-mathematical considerations may outweigh the small benefits in either direction."

Links well to the existing text and provides good balance.
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LadyGeek
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Re: Decision on wiki: Paying Loans vs. Investing

Post by LadyGeek »

I don't understand the part about municipal bonds, underlined below.
assumer wrote:
If the decision is close: If the decision is close, it is likely to be better to keep the loan. One reason is that you can refinance your loan if interest rates fall, so the effective cost of the loan to you could be slightly less than it's interest rate. For comparison, the Treasury cannot refinance its bonds so it can not take advantage of lower rates. Most municipal bonds have only limited call provisions. In addition, if the choice is between investing in a 401(k) or IRA and paying down the loan, investing in the 401(k) or IRA will give you more tax-deferred investments, which will remain valuable even after you have paid off the loan.
This thread is now in the Investing - Theory, News & General forum (general investing).
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azanon
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Re: Decision on wiki: Paying Loans vs. Investing

Post by azanon »

assumer wrote:I was going to change that section because I didn't necessarily think that paying down loans should be forgone for purchasing bonds when the decision is close, but I wanted to come to a consensus on here before doing anything. My original thought was that getting yourself out of debt is most of the time the best decision because it reduces your risk, is a guaranteed, tax-free investment, in addition to psychological factors.
It doesn't necessarily reduce your risk, depending on your overall portfolio. I personally use my low-interest home loan (it's 3.37%) as my inflation-protection component of my portfolio. Popular alternatives to protect against inflation (TIPS, Gold, others) are arguably very overpriced. I'm going to feel really cozy in the event that interest rates shoot up over the next few years, and I'm still sitting pretty on my moderately sizeable 3.37% home loan. And yes - I itemize, so it's actually even less than that, in reality.

And to be clear, if I can't beat 3.37% nominal with the rest of my portfolio, I am a very sad investor indeed. I use 80% equity, 2/3rds of which is foreign. So I definitely expect to greatly exceed 3.37% nominal long-term. So is that borrowing money to invest? I guess from a certain point of view. But it is really such a bad thing? Banks do it all the time.
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momar
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Re: Decision on wiki: Paying Loans vs. Investing

Post by momar »

My risk is reduced when I have a loan at close to bond rates and also liquid investments equal to the value of the loan. My risk is higher if I paid off my loan and had no money left.

I can't eat my house, but I can pay my mortgage and buy food with the same money.
"Index funds have a place in your portfolio, but you'll never beat the index with them." - Words of wisdom from a Fidelity rep
bdpb
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Re: Decision on wiki: Paying Loans vs. Investing

Post by bdpb »

azanon wrote: And to be clear, if I can't beat 3.37% nominal with the rest of my portfolio, I am a very sad investor indeed. I use 80% equity, 2/3rds of which is foreign. So I definitely expect to greatly exceed 3.37% nominal long-term. So is that borrowing money to invest? I guess from a certain point of view. But it is really such a bad thing? Banks do it all the time.
Since you own bonds already, there is no need to borrow money at 3.37% to invest in stocks. Instead, sell your bonds yielding 2% and buy stocks.

When you borrow to invest you should compare the debt to an investment with similar risk, bonds. Otherwise, you are taking on more risk. If you want to take on more risk, either borrow from the bank at 3.37% or borrow from yourself, your bonds, at 2%.
Topic Author
assumer
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Re: Decision on wiki: Paying Loans vs. Investing

Post by assumer »

Okay, so how about presenting it as such? How should I discuss what happens with rising interest rates?
If, by the sheer numbers, the decision is close, it may be better to keep the loan.

The benefits of paying off the loan would be:
  • Psychological benefits listed above.
  • Reduced minimum monthly payments, which could be useful in an emergency situation.
  • Tax-free return.
The benefits of keeping the loan and investing in bonds would be:
  • Liquidity (you can likely choose to sell the bonds and pay the loan off at any time)
  • If interest rates fall, you can likely refinance the loan at a lower rate.
  • Fixed-rate loans (e.g. mortgages) can offer inflation protection (if inflation rises, you are still only paying the same nominal amount per month).
  • If the choice is between investing in tax-advantage accounts (e.g. 401(k) or IRA) and paying down the loan, investing in the 401(k) or IRA will give you more tax-deferred investments, which will remain valuable even after you have paid off the loan, and these accounts have annual contribution limits.
Unless somebody here can clarify LadyGeek's question about the following, I say we remove it.
Most municipal bonds have only limited call provisions.
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JamesSFO
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Re: Decision on wiki: Paying Loans vs. Investing

Post by JamesSFO »

I think overall that is a good summary. I don't think the advice radically changes in a rising interest rate environment assuming a fixed interest loan. That said the MATH will change, in a rising interest environment comparing the two will me one or the other will more quickly be favored...
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Re: Decision on wiki: Paying Loans vs. Investing

Post by Dulocracy »

It may be too late for this response, but if the issue is between paying loans and investing when the numbers are close, I think the answer becomes liquidity goals. Allow me to explain:

Liquidity or the availability of liquid funds can often mean greater financial stability. This is why we recommend emergency funds. If the debt is a longer term debt, such as a mortgage, a decision for liquidity may suggest increasing investments. If, however, there is a shorter term debt, paying it off may provide stability in that the monthly expenses are lower. That is, a low interest student loan that would take 5 years to pay off could be paid off in one year. At the point of payoff, money from an emergency fund would go further.

Obviously, there are multiple strategies that can come into play, but I think the answer is something like: Pay off shorter term debts to free up cash-flow and reduce recurring liabilities, but invest in liquid assets when the debt is not likely to be paid off in a short period of time. (Of course, this test is only after determining that the two methods are mathematically the same).
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.
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