Investing All-in-One For Dummies. Eric Tyson

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Название Investing All-in-One For Dummies
Автор произведения Eric Tyson
Жанр Личные финансы
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Издательство Личные финансы
Год выпуска 0
isbn 9781119873051



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living expenses as an emergency reserve (see Chapter 1 in Book 2). Invest this personal-safety-net money in a money market fund (see Chapter 4 in Book 2). You may also be able to borrow against your employer-based retirement account or against your home’s equity, should you find yourself in a bind, but these options are much less desirable.

      If you don’t have a financial safety net, you may be forced, under duress, to sell an investment (at a relatively low price) that you’ve worked hard for. And selling some investments, such as real estate, can take time and cost significant money (transaction costs, taxes, and so on).

      

Riskier investments like stocks aren’t a suitable place to keep your emergency money invested. While stocks historically have returned about 9 percent per year, about one-third of the time, stocks decline in value in a given year, sometimes substantially. Stocks can drop and have dropped 20, 30, or 50 percent or more over relatively short periods of time. Suppose that such a decline coincides with an emergency, such as the loss of your job or a health problem that creates major medical bills. During the 2020 government-mandated economic shutdowns due to the COVID-19 pandemic, remember how (U.S. and most international) stocks dropped more than 30 percent in just a few weeks while millions of people lost their jobs? Your situation may force you to sell at a loss, perhaps a substantial one. Stocks are intended to be a longer-term investment, not an investment that you expect (or need) to sell in the near future.

      Getting out from under 18 percent interest rate credit card debt is clearly a priority and a bit of a no-brainer. But what should you do about other debts that carry a more reasonable interest rate? This section talks you through some common examples: student loans and mortgage debt.

      Assessing student loans

      If you’re one of many young adults with lingering student loan debt, you’re probably wondering whether you should focus your efforts on paying down that debt or instead invest the extra cash you have.

      The best choice hinges on the interest rate on this debt (after factoring in any tax breaks) and how that compares with the expected return from investing. Of course, you must be reasonable and not pie-in-the-sky about the rate of return you expect from your investments.

      If you can deduct student loan interest on your tax return, to determine the value of that deduction, see Chapter 2 in Book 2 to understand what tax bracket you’re in (what your marginal tax rate is). For most moderate income earners, 25 percent is a reasonable number to work with.

      Suppose you have student loans outstanding at the attractive interest rate of just 3.5 percent. Assume that you’re able to deduct all this interest and that your income tax bracket is 25 percent. So, after taxes, the effective interest rate on your student loan is 3.5 percent – (0.25 × 3.5 percent) = 2.63 percent.

      Now, the question to consider is this: Can you reasonably expect to earn an average annual rate of return from your investments of more than this 2.63 percent? If you invest your money in a sleepy bank account, the answer will surely be no. If you instead invest in things like stocks and bonds, over the long term, you should come out with a higher return.

      If you have student loans at a higher interest rate — say, 6 percent — it may make more sense to pay those loans down faster with your extra cash than to invest that money elsewhere. To get a higher return than that from investments, you need to take a fair amount of risk, and of course there’s no guarantee that you’ll actually make a high enough return to make it worth your while.

      When deciding whether you should pay down student loans faster, there are some factors to consider besides the cost of your student loans and comparing this cost to the expected return on your investments. Other good reasons not to pay off your student loans any quicker than necessary include the following:

       Paying off your student loan faster has no tax benefit. Instead, you could contribute to your retirement (also known as tax reduction) accounts, such as a 401(k), an IRA, or a SEP-IRA plan (especially if your employer offers matching money). Putting additional money in a retirement plan can immediately reduce your federal and state income tax bills. The more years you have until retirement, the greater the benefit you receive if you invest in your retirement accounts. Thanks to the compounding of your retirement account investments without the drain of taxes, you can actually earn a lower rate of return on your investments than you pay on your student loans and still come out ahead.

       You’re willing to invest in growth-oriented investments, such as stocks and real estate. To have a reasonable chance of earning more on your investments than it costs you to borrow on your student loans, you must be aggressive with your investments. Stocks and real estate have produced annual average rates of return of about 9 percent. You may be able to earn even more in your own small business or by investing in others’ businesses. Keep in mind that you have no guarantee, especially in the short term, of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year or two.

       Paying down your student loans depletes your emergency reserves. Psychologically, some people feel uncomfortable paying off debt more quickly if it diminishes their savings and investments. You probably don’t want to pay down your debt if doing so depletes your financial safety cushion. Make sure you have access — through a money market fund or other sources (a family member, for example) — to at least three months’ worth of living expenses (see the earlier section “Establishing an emergency reserve”).

      Considering paying down mortgage debt

      Paying off your mortgage more quickly is an “investment” for your spare cash that may make sense for your financial situation. However, the wisdom of making this financial move isn’t as clear as is paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is typically tax-deductible.

      As with the decision to pay off a student loan faster (look to the previous section), when evaluating whether to pay down your mortgage quicker than necessary, compare your mortgage interest rate with your investments’ rates of return. Suppose you have a fixed-rate mortgage with an interest rate of 5 percent. If you decide to make investments instead of paying down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of more than 5 percent for you to come out ahead financially.

      

Don’t get hung up on mortgage tax deductions. Although it’s true that mortgage interest is usually tax-deductible, you must also pay taxes on investment profits generated outside retirement accounts. You can purchase tax-free investments like municipal bonds, but over the long haul, such bonds and other types of lending investments (bank savings accounts, CDs, and other bonds) are unlikely to earn a rate of return that’s higher than the cost of your mortgage.