I’m always reading articles and listening to “financial gurus” who tell individuals ***with extra money*** not to pay down low interest rate debt. Instead, the expert advises paying the minimum on mortgages and student loans so the difference can be invested in stocks. In theory, this will give the individual greater returns, as the stock markets historical average of 10% trumps prepaying the lower interest debt. On the surface this advice sounds logical, and perhaps even financially sophisticated; however, proponents of this method are completely ignoring risk.
By taking extra money and investing it in the stock market, one is forgoing a risk-free return on their money in favor of an investment that’s inherently risky. This isn’t necessarily a bad thing, provided that the investor understands that the potential for greater returns comes at the expense of increased risk to their hard-earned capital. Only by dialing up the risk do we up the potential for higher returns. This is the reason comparing the long-term return of stocks to the risk-free return of prepaying a loan is unwise. Instead, I suggest comparing the loan prepayment return to that of another risk-free investment such as a treasury bond or CD. When you make an apples to apples comparison you’ll see that prepaying the loan isn’t such a bad choice.
Remember, most of the truly disastrous financial mishaps in history were caused as a direct result of ignoring risk. If risk was accounted for properly on Wall Street and Washington we wouldn’t be in our current situation. Always be sure that you understand the risks before making a financial decision.
***This post is referring to individuals who are already fulfilling their financial obligations (i.e.: they have no high-interest debt, have an emergency fund, and are already contributing to retirement accounts.) Thus they are asking what to do with additional free cash from earnings or perhaps even a windfall such as an inheritance***
Honestly, if I had so much extra free cash, I’d blow it one night in vegas with the guys! j/k, but not really!
Yeah, the best barometer I have is the 10-yr treasury risk free yield for buying rental properties, and then that risk free rate + perhaps 5% to get my required rate of return for investing in the market.
Frankly, I don’t co-mingle my funds. I ear-mark my retirement funds in a guaranteed return type investment, and the minority rest, I whip it around like a cowboy.
That’s a good method FS! I have nothing against putting extra cash in the market, but it drives me crazy when people think they’re blindly going to get a higher return then the one they could have had paying off the debt.
I guess I look at allocating extra funds conservatively b/c my job depends on the stock market and my retirement money is mostly in stocks. So anything extra I have I’d rather use to hedge myself by paying down a mortgage or other debt.