If you come into a fair amount of money, don’t ignore the fact that you can invest in your debt.
Sometimes paying down debt can save you much more money than you can earn with another option. Additionally, paying off a loan in full will increase your future cash flow. Read on for a look at debt as an investment and a closer look at tax-equivalent yield.
Pay it Down and Invest in Your Debt
In my last article I took a look at various investments you should take a look at now. I didn’t mention another option for your cash- paying down your debt. Household debt in the United States is still at a very high level (even after recent improvements). You probably have some debt yourself between credit cards, student loans, mortgages and home equity loans, and car loans. What’s worth paying off?
More Tax Equivalent Yields
Say you just took out a car loan for $20,000 at 5.00% APY (make this math a little easier…) over 5 years. “5%?”, you say, “I can make 7% in my sleep on the stock market…” (or any other investment route). Well, that’s pretty confident, but you need to compare equals.
Say you make $50,000 a year and you live in California. You’re paying 25% in federal taxes and 9.55% in California taxes for short term capital gains.
5.0% / (100% – 34.55%) = .05 / .6545 = .07639 = 7.639% tax equivalent yield.
How about for a long term gain? In that case you would pay 15% in federal taxes and 9.55% to California.
5.0% / (100% – 24.55%) = .05 / .7545 = .06627 = 6.627% tax equivalent yield.
So for this specific example, if you hold your stock for over a year, you’ll come out on top. That’s not the important part though (if it was, I would have chosen better numbers!)… the important part is you compare like numbers. Make sure you calculate the return you would need pre-tax before you invest your money. Also, note that if you didn’t pay it off, you would pay $2,645.48 in interest over the life of the loan. Interested now?
Note that for mortgages, the calculation is different. See this awesome mortgage post for a closer look at this complicated issue.
Freeing up Your Cashflow When You Invest in Your Debt…
Let’s use that same 5% car loan as an example for this second point. You would be making a payment of $377.42 a month on this loan. This is equivalent to a bond that pays a coupon of $576.65 monthly, pre-tax (for the same scenario as above). Freeing up your cash flow is a good ancillary benefit to paying down debt.
Get to it!
Before you decide what to do with your money, at least take a cursory glance at the numbers if you invest in your debt. You may find an opportunity where you didn’t expect it.