People come to me for different reasons. One recent encounter was when a couple received an inheritance. It wasn’t huge, maybe $50k, but they wanted to know what to do with it. I went through the basic planning steps and found that they had no savings and had credit card debt and an RV loan. They were contributing enough to get the match from their employers in their 401ks, but that was it. Without thinking, my immediate suggestion was to take the money and pay down all of their debt. The credit card loan carried an interest rate of 21% and the RV loan was 9% over 10 years. They were adamant about using the money to fund a 529 plan for their 9-year-old child. What do you think they should do? Was my off the cuff response correct?
They didn’t like my advice at all. The idea of not setting something aside for their kids was unacceptable in their eyes. They opted to go elsewhere which was fine with me. I knew I was right, and given the opportunity I would have shown them the math. Here are the pertinent inputs for this couple. As always, don’t take this as gospel, everyone should run the numbers for themselves:
Ages: Each 34 with a 9-year-old child
Income: $180k Gross
Living Expenses: $84k per year plus another $19k for home related expenses
Credit Card: 21%
RV Loan: 9%
$640k mortgage: 3% rate
Assume excess cash flow is invested moderately at a 5.53% annual return (I use low rates to model a worst case scenario).
Inflation: 2.5%
The thing that jumps out immediately is the rate they are paying for their debt, 21% and 9%. This is a certain cost and unfortunately too common. Those rates are highly unlikely to go down or get refinanced lower without some sort of cost. The investment return on the excess cash flow is 5.5% which is also the rate I used for the 529 annual returns. That 5.5% is uncertain. You are going to have good years and bad by investing. If you want to think like a bank, you look at the spread between the rate at which you can borrow and what you can earn. For ease of this discussion, let’s look at long term rates of return from a reputable institution. Here is a handy chart from our friends at Fidelity showing rates of return for different investment mixes over time:
Data source: Fidelity Investments and Morningstar Inc. 2024 (1926–2023). Past performance is no guarantee of future results. Returns include the reinvestment of dividends and other earnings. This chart is for illustrative purposes only. It is not possible to invest directly in an index. Time periods for best and worst returns are based on calendar year. For information on the indexes used to construct this table see Data Source in the notes below. The purpose of the target asset mixes is to show how target asset mixes may be created with different risk and return characteristics to help meet a participant's goals. You should choose your own investments based on your particular objectives and situation. Remember, you may change how your account is invested. Be sure to review your decisions periodically to make sure they are still consistent with your goals. You should also consider any investments you may have outside the plan when making your investment choices.
Over the nearly 100 year period in this chart you have done well on average by staying invested vs. stuffing it under the mattress. Remember, these average rates aren’t certain. What happens if you stumble upon one of those worst 12 month or 20 year periods and you need those funds for oner term need, like college? Not only are you negative or at a low return, but you’ve paid high interest rates on debt as well which compounds your problems. Plus, the debt in my example carries a higher average rate than the most aggressive average return in this chart. A bird in the hand is worth two in the bush! I say that almost daily. Take that $50k and pay off that debt first. Then worry about funding college.
What about their mortgage debt? They didn’t ask about this, but for fun I thought I’d include it for a more robust discussion. In this case their mortgage interest is 3%. Mortgages last typically 30 years. Should they prepay mortgage debt, or should they fund investments over prepaying their mortgage? This isn’t as easy of a question. It depends on your risk tolerance. The worst 20 year period in a balanced portfolio returned 3.43% and the best was 13.84%. Both these rates are higher than the 3%. I’d say invest it due to the odds being in your favor! My rule of thumb is that if you can earn a higher rate of return on an investment with some degree of certainty vs. the interest rate you pay on a loan, you need to invest it. From roughly 2010-2021mortgage interest rates were below 5%. (St Louis Fed) You could get a mortgage for around 3% but could only get a guaranteed rate of return of about 1% if you were lucky. If you are unwilling to take risk, yes, go ahead and prepay the mortgage. You’re saving cash at 0.5% to 1% while paying 3% plus on a mortgage. Fast forward to today and you can get a guaranteed rate on a money market at 5% (which will be subject to the change in short term interest rates) or you can lock money into a 5 year CD for about 4%. (Source: Bankrate.com 5/29/24) If you’re paying 3% on a mortgage and getting 4% or 5% guaranteed depending on how long you want to lock it up, you want to invest. Ignoring potential taxes, that spread of 1%-2% is yours to keep.
This is how banks work. They just do it with billions (trillions?) of dollars. It’s called Net Interest Income. They lend out long term at a higher rate and pay a lower rate for your savings and money market deposits. In my example family, they are upper middle class. If they pay off that debt and put savings toward investments, they’re making money like a bank does: collecting money on the spread between rates. This time you are borrowing long at a low interest rate and lending short at a higher rate. Banks hate this because it disrupts their business models. I don’t feel sorry for mega banks though! They get bail outs when they make an error and don’t manage their balance sheets properly. We get a bankruptcy on our record. Look at the Great Recession. Banks had toxic assets on their balance sheets which went belly up. We had excess debts, especially mortgages, that couldn’t possibly be served by their cash flows (remember the strippers from “The Big Short”?). It’s no different than carrying revolving debt and investing in risk assets.
The bottom line is certainty. If you can get a risk free or nearly risk-free rate of return or higher than the rate you borrow money, go for it! If you need to take substantial risk, like the stock market, you might want to think twice before maxing out your credit cards to buy the lates meme stock. It doesn’t matter if you are a millionaire or middle class. So how did my research fare? I never did show whether I was right in my suggestion. What do you think the couple should do? Here are the 4 options. I included paying off the mortgage and just investing funds in a taxable account instead of the 529 for fun:
Scenario | Net Worth at age 40 | Net Worth at 60 | Net Worth at 80 | Probability of Success |
Pay off Mortgage | $249,655 | $1,038,830 | $1,155,885 | 63% |
Put 50k toward a 529 plan | $248,570* | $1,377,381 | $2,143,815 | 76% |
Invest 50k in a moderate basket of stocks | $359,882 | $1,395,454 | $2,199,651 | 76% |
Pay off RV and Credit Card | $352,051 | $1,499,896 | $2,223,525 | 81% |
*This scenario assumes the 529 assets are removed from the client’s net worth and out of the estate. All assets from the 529 are spent on college costs when the 9 year old goes to school
There you have it. To be fair there isn't much difference in the ending net worth values unless they prepay their mortgage. However, look at the probability of success to retire and pay for school. It's 5% higher just because the Monte Carlo simulator recognizes volatility of returns. So you are getting a little more money for less risk, win-win! The probabilities don't change dramatically if we adjust to a higher, risker, rate of return on excess cash flow and 529 investments. I’m not always right, but I do know the basics of how to think like a bank. The math doesn’t lie. It’s too bad I didn’t get their business, but I’d rather not do anything for a client than facilitate a wrong move. Yes, I know mortgage rates are higher right now so a lot of this may not be applicable to you if you're looking to buy a house right now, but hopefully you get the gist of the message: think and act like a bank knowing damn well you won't get a bail out :) Reach out if you have scenarios you’d like to see in this blog or if you would like to chat.
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