Divvying Up Dollars

Adam M. Grossman

IF YOU HAVE A SURPLUS in your household budget, what’s the best use for it? Does it make more sense to pay down debt or to invest those extra funds? With interest rates at such low levels, this is a question I’ve been hearing with increasing frequency.

Suppose your mortgage rate is 3.5%. If you pay down that debt, it’s like earning 3.5%. By contrast, if you invested in the stock market, your annual return would be uncertain. You might earn more than 3.5%, but there’s also the possibility you could earn less—this year being a case in point.

Historically, the U.S. stock market has gained 10% a year, on average. Even if the market did just half as well in future, you’d still be doing better than 3.5%. It seems like there’s an easy answer to this question: The rational choice would be to invest any extra money you have.

That’s the logical answer—and it’s hard to dispute—but I don’t think it’s the only answer. Instead, I see this as a question with a lot of nuance. I would also consider the following five issues:

1. Taxes. If you’re doing a calculation like the one above, be sure to adjust for taxes. Most debt doesn’t carry a tax deduction, but mortgage debt does (up to $750,000, or $1 million for home purchases prior to 2018). That means that, if you itemize your deductions on your tax return, a 3.5% mortgage might be costing you little more than 2%—or even less if you’re in a high federal tax bracket, plus you live in a higher-tax state like California.

Similarly, every investment has a different tax profile: Some stocks issue dividends, while others don’t. And in the bond world, some pay interest that’s subject to income tax, while other bonds don’t. Bottom line: If you’re doing a comparison, be sure to compare apples to apples.

2. Leverage. When I was in school, I remember learning an economic theory called the Modigliani-Miller theorem, which stated that companies should be agnostic as to how they raise money. Whether they issue shares or take on debt, it shouldn’t make a difference, even if that means the company ends up highly indebted. When I first heard this concept, I thought it was crazy, and I still do.

That’s because debt matters. To put it in simple terms, companies with no debt can’t go bankrupt. The same is true of individuals and families. During good times, debt may be very manageable. But this year is a good example of how life can throw financial curveballs. Even when the math says that you’re better off investing, it’s worth reviewing your overall balance sheet and asking whether it would, nonetheless, be worthwhile to reduce your debt load.

3. Liquidity. It’s important to think about your overall debt load, but it’s also important to think about the relationship between indebtedness and liquidity. If you pay down a dollar of debt today, that may give you more flexibility in a rainy-day scenario. But if you keep that same dollar in the bank, you’ll have more flexibility for other things. That might include an unexpected expense or maybe an investment opportunity. There’s no scientific way to strike this balance, but it’s usually prudent to avoid going to either extreme.

4. Personal preference. Let me describe two people I know: I’ll call them Joe and Sam. Joe has lived in the same house for 20 years, and yet he has virtually no home equity. This is intentional, and he’s proud of it. Over the years, Joe has refinanced his mortgage more than 10 times, often taking money out. Joe’s view: With rates so low, he’s happy to continue rolling over this debt, and this gives him the flexibility to use his money in other ways. He plans to do this for as long as he can. In his words, “If I don’t ever have to pay for my house, why should I?”

Now let’s look at Sam. He has also lived in the same house for 20 years. He started with a 30-year mortgage, but has been making extra payments all along and is nearly done paying it off. Who’s right, Joe or Sam? To be sure, you could do the math and maybe prove that one or the other made the better choice. But there’s something else going on, and that’s personal preference.

Some people just don’t mind living with large amounts of debt, while others are the opposite—they dream of not owing a penny to anyone. Most people fall somewhere in the middle. But if you’re clearly a Joe or a Sam, the math might not matter as much as your personal preference—and I think that’s perfectly okay. Personal finance isn’t about optimizing every dollar. It’s about optimizing happiness and peace of mind. To be sure, you shouldn’t make choices that jeopardize your financial security. But if you’re considering two reasonable choices, you don’t always need to do what the math says is “best.”

5. Market valuations. I often talk about the dangers of market timing—trying to predict whether the stock market will go up or down. But there’s a big difference between trying to predict where the market is going and simply reacting to what it’s already done.

If you have a surplus in your budget, you might opt to invest more when the market is down than when it’s flying high. You might do this formulaically, such as tying the size of your investments to the level of the S&P 500, or you could do it informally. Either way, depending on where the market stands, stocks may be more or less attractive—and you might invest accordingly.

Adam M. Grossman’s previous articles include Less Than the TruthNo, I’m Better and A World of Problems.  Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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james mcglynn
james mcglynn
3 years ago

Since Joe and Sam are single the tax deduction might still work. For married couples with the high standard deduction it is harder to itemize. In favor of NOT paying do own the mortgage and having the liquidity is avoiding an expensive reverse mortgage. How many folks have paid off their mortgage only to need to raise liquidity through a reverse mortgage later? Liquidity is underrated and could be used to purchase long term care insurance.

Mr Moderate
Mr Moderate
3 years ago

Great article, Mr Grossman. This is also a continuing debate I have with myself. We owe about $112k on a house currently valued at $260k. I am 62. My wife and I have enough to pay off the remainder on the mortgage with some of our 401k/457/Roth accounts. However, our mortgage interest rate is 3.25% and we get a tax write-off. I think it also depends on the amount of the remaining mortgage, let’s say $150k vs only $30k. At this stage in our lives if we had only $30 left, I’d be tempted to pay it off for the emotional benefit. One also needs to make sure you don’t become “house-rich & cash-poor” into a possible recession/depression in which houses don’t sell and house prices fall. What you say about dividend income from our stock investments also is helpful as we have about a 2.5 to 3.0% yield being overweighted value funds and some international ETFs. So, again, thanks for the reminders and advice on this not solely black-or-white issue. We are fortunate to have options. Perhaps we will end up paying off some but not all of the remainder as as means of diversification.

Peter Blanchette
Peter Blanchette
3 years ago

Are you implying that the financial condition of Joe and Sam are basically the same except for rounding preferences? The guy who is constantly refinancing sounds like a guy who is crying out for help! I know it was a long time ago(way back in 2008) but the refinancing boom of that time was characterized by people who could not finance a decent lifestyle except by constant refinancing of their assets. We are generally told by our financial advisors that debt should be used primarily for the capital needs of our lives(home, education,medical bills during stressful times etc).

R Quinn
R Quinn
3 years ago

Excellent article and food for thought. I’m in the no debt camp. Aside from a mortgage which is gone, I never had any debt even for cars and I like it that way. I can’t even wait until the end of the month to pay off my Amx and nothing gets put on a card unless I’m sure I can pay in full monthly.

2 years ago

So interesting. We’re on the verge of refinancing our mortgage and paying off our last car loan, and those two things together will save us several thousand dollars a month. I’ve been debating about what we should do with that surplus. We already contribute the maximum to retirement accounts, more to regular savings, and have an ample emergency fund.

We’re turning 60 this year. Our only debt once the car is paid off will be our mortgage, which we’re restarting to 30 years with the refi. Every personal finance book I’ve ever read screams to go into retirement with no mortgage. So…we should put the monthly surplus into paying down the mortgage, right?

But…when we retire, we will have enough guaranteed income between pensions and Social Security to live comfortably, including our mortgage payment. The new mortgage will be 3.125%, and we live in California, where the tax deduction will be helpful.

The issues and questions here are exactly what we’ve been kicking around. One size doesn’t always fit all.

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