What if I told you that I could guarantee you 6% on your money right now without any risk? Would you suspect I was in the mafia? Maybe I was insider trading and trying not to be so obvious as to arouse the suspicion of the authorities. Perhaps I was a stock market genius? Well for a lot of people I can guarantee that return and there’s nothing illegal about the method I’m about to say.
PAY OFF YOUR DEBT! Student loans and especially credit card loans typically carry interest rates of more than 6%. These payments eat away at your savings faster than a hungry moth in a closet full of clothes (hopefully that makes you view debt as kinda nasty). Few kinds of debt are tax deductible for individuals. For example, only a small part of student loan interest can be deducted and mortgage interest is one of the few that can be deducted in full. This fact means that to pay a 6% interest rate, you have to earn more pretax to get the dollars to pay for it. If you are a pretty successful young professional making a good salary, your marginal tax rate (% you give to the government for each extra dollar you earn) is probably at least 30% if you live in a medium tax state like a North Carolina, Georgia, Pennsylvania, or Ohio. It is even higher if you are living in New York or California as you could be approaching 35-40% as your marginal rate. Say you had to pay $10,000 a year to pay down what you owe from college. We are going to use the 30% tax rate to make the math straightforward. To get the $10,000 you need to pay the loan since it’s not tax deductible, you have to earn 10000 / (1.00-0.30) which is about $14,300. That’s equivalent to close to a 8.5% return that you’d have to get on your money, pay taxes, then use the gains to break even on the interest you have to pony up.
The reason paying off any and all debt with a 6% interest rate or higher is so smart is that the experts are thinking the stock market might return around 7% for the next 10 years or so based on moderate economic growth. This means you can beat the consensus return on the stock market by 1.5% or more just by paying down your loans, and it’s guaranteed! There’s no chance like there is in the stock market that you lose 50% of that money and you panic and sell at the wrong time. It’s straight up math. Pay down the balance of the loan and you’re rivaling Ahhnold in the next Terminator movie as to how much hurt you are bringing to the forces that would have you save little to nothing. Another fun fact. Beating the market by 1% consistently is considered a great feat by stock picking professionals. That means you are besting even the smartest minds in the financial industry by taking any extra cash you have laying around and paying off your debt as fast as possible.
A quick comment on the most common forms of debt that are under 6% in interest right now, mortgages and car loans. The mortgage interest, while tax deductible and averaging 4% right now, should never be thought of as a big benefit. If you’re saving a ton on your taxes because you are paying a ton in mortgage interest that means your house is too big and you’d save a ton by living in a more modest home. Car loans for borrowers with great credit scores could be 2% or lower but if you have a car payment on a vehicle that cost you more than $10,000, then you should probably look into selling that vehicle if you can avoid taking a big hit on what you’d owe after selling it. Just because a loan has a low interest rate doesn’t mean that you’re getting a great deal. That’s how furniture stores trick people into buying really marked up merchandise. If they give you zero interest for 60 days you’re still spending $3000 on a couch so what do they care what your interest rate is?
Good luck on lowering those debt loads. Once you have your debt paid down you can take those extra dollars and put them to work for you in an investment portfolio and watch how cool it is when your money is working for you and not against you!