Recently my mother and father-in-law purchased a lake house on which they took out a mortgage.
Since she knows what I do for a living, she sought my counsel about the best methodology for paying off the mortgage as quickly as possible. She asked my opinion about pulling funds out of her Roth IRA and applying that money to the principle.
I thought about it for a second and then gave her what was, admittedly, no answer at all. I told her it depends on a ton of factors. Among other things, your tolerance for risk, your liquidity needs, your interest rate, and your tax bracket would all have to be considered before providing an accurate answer.
However, the question did get me thinking about the relationship between getting rid of debt and saving for the future. I began questioning whether the average American is placing a priority on the option that will provide the biggest long-term advantage. I brought the subject up with a colleague over lunch that day.
My question was a simple one: If most people who carry debt carry it at a fixed rate and, at the same time, their investments grow at a fluctuating rate, how much more must the anticipated gains be in their investments to justifying not using those funds to pay off debt?
My lunchmate appeared puzzled, so I explained further. If a fair expectation for your investments is 7 percent annualized and you have a fixed rate mortgage at 5.5 percent, does it make sense to accept market risk on your money for a possible 1.5 percent in additional growth?
I could see the wheels turning in his head, and it didn’t take him long to reply. Most people, he explained, receive a significant tax deduction on the interest they pay on the mortgage, and a significantly more than 7 percent growth on their retirement savings because of the employer match that often exists within an individual 401(k).
That answer made sense. But then I asked a follow up question: In that same scenario, what if we replace “mortgage interest” with “credit card interest” and replace “retirement savings” with “college savings”?
At that point he said, “Do you really think people with credit card debt are saving for their kid’s college?” Not knowing the answer, I acquiesced.
But the question continued to gnaw at me. The more I thought about it, the more I decided that people are probably doing things they think are responsible but, in reality, are actually financially unwise. So, I decided I needed to look at the data.
What I found was very interesting. According to a recent study, roughly 40 percent of Americans carry credit card debt at an average total of approximately $16,000. (www.valuepenguin.com/average-credit-card-debt)
At the same time, approximately 72 percent of Americans are saving for a child’s or grandchild’s college. (www.fidelity.com/about-fidelity/individual-investing/10-year-college-progress-report)
By simple logic, these two stats tell me that at least 8 percent of Americans have credit card debt and, at the same time, are also saving for nonretirement-related expenses, though the number is probably higher than that.
If you consider that a reasonable long-term expectation on your investments should be roughly 7 percent annually and the average credit card interest rate is 15 percent annually, then we have a problem. (www.creditcards.com/credit-card-news/interest-rate-report-32217-up-2121.php
There are people in this country literally borrowing money from a bank at 15 percent interest and then investing that money in the market hoping for a 7 percent return. I’m no math whiz, but even I know that’s a bad deal.
If you’re reading this and wondering if you’re doing the right thing when it comes to your financial future, I would encourage you to speak with your financial adviser. If you don’t have one, now is the time to get one. A small amount of analysis could save you thousands of dollars over your lifetime.
(Past performance is no guarantee of future results. All advice is meant to be general in nature and not specific for any reader.)
Ron Finke is president of Stewardship Capital in Independence. He is a registered investment adviser. Reach him at firstname.lastname@example.org.