09 September 2007

Debt vs investment: pay now or pay later?

So you have some spare cash. Should you invest it or pay off debts? That depends on how you like risk
AS a financial planner, I have often been asked if one should use spare cash to redeem a loan or invest the money instead. Or if one should cash out of an investment to pay off debt.
The first rule of financial planning is to save at least three to six months of your income as an emergency fund. Any money left over can be used to pay off debt or invested. Remember that monthly debt repayment eats into your financial plan but investments will increase your net worth.
Making early payments to pay off your loan exposes you to relatively few risks as once the loan is paid, it stays paid. But there is another type of risk associated with early repayment and that is opportunity risk. The opportunity risk is the possibility that a better opportunity might present itself and you would be unable to take advantage of it since you gave the bank your extra cash to redeem the loan. And when you invest your money, you generally expose yourself to market risk and other risks that could make you lose money.
Paying debt early may not be wise if the loan is for an investment property that is rented out. The interest paid on home mortgages is tax deductible against the rental income. This will effectively reduce taxable income derived from rental income. However, this strategy does not apply to owner occupied property or any other loans. In such cases, it will make sense to reduce your loan.
Bank overdrafts and credit card debt must be paid as soon as possible. Using credits cards has no ill consequences when you pay them off monthly. The high interest charge on installment debt, however, turns potential savings into healthy profits for the lending institution. In contrast, this money could be growing in your investment account instead. Few people realise how long it takes to pay off installment debt once the bills start arriving. Charging is all too easy.
So, say you have a debt as well as cash for investment. If you maintain the debt (instead of paying it off), the cost to you is the interest rate on the loan minus whatever you make from the investment. Basically, you are trying to determine whether you can achieve a return on your investment that is far superior than the interest rate on the debt.
For instance, if the interest rate on your mortgage is 5 per cent, and you can find an investment that gives you 9 per cent, you should certainly invest your money. In reality the analysis is never this simple, because you need to know the return on investment which is difficult to ascertain.
Although it is impossible to predict with certainty what an investment will return, we can still be sure of two certainties, ie, the likely return and the level of risk. Since paying down any debt entails much lower risk than making an investment, you need to get a higher level of return to offset the additional risk taken on the investment. In other words, the investment has to pay you a higher return to assume the risk in order to justify the investment.
So it would be foolish to turn down a risk-free return of say, 4 per cent, to try to get a return of 5 per cent from another investment where the returns are not guaranteed. (This concept is similar to our CPF Special Account where the 4 per cent interest is risk-free and the returns on other investment are not guaranteed, at best only the capital is guaranteed.)
It is a matter of personal preference how big the difference between the return on the investment and the risk-free return should be. Technically, this is called the risk premium.
By now we are convinced that paying the debt is a low-risk alternative. But when it comes to selecting investments that will potentially yield more than paying down a debt, you have many options. The option that you choose should be the one that maximises your return subject to a given level of risk.
In Singapore, investment options are plenty. So if you have a mortgage interest rate of 5 per cent, where would you want to invest for higher returns? Obviously, you will choose an investment that provides a return higher than your mortgage rate. In this case, unit trusts and stock investment seem to stand out. Historically, these investment have earned about 7-10 per cent or more over long periods of time, but losing money is a serious possibility over a shorter period, say, less than three years.
The question of whether you should put all your extra cash into the market versus paying off your mortgage will depend on your risk appetite. For me, the answer is somewhere in between. Everyone agrees that it is good to be debt free, but paying down your debts to the point where you have no available cash could really hurt you if you need cash for emergencies.
And, of course, it would be nice to have lots of long-term investments, but don't neglect the guaranteed rate of return that is assured by paying down debt versus the completely un-guaranteed rate of return found in the markets. If having a debt makes you nervous, then pay off the loan. If you don't worry about debt, then keep the mortgage and keep your money invested. If you can understand the ups and downs of the market, then invest in stocks or unit trusts. Lastly, if the stock market makes you nervous, pull out some or all of your equity investments.
In life, all we can do is "guess-timate" and hope we did the right thing. You'll have to make your call today and see what it garners tomorrow. In short, each of us needs to find the right balance between risk and reward.

1 comment:

Anonymous said...

Wow... Good idea. Until now then I understand 'debt' and 'investment'.
Thanks for this useful information.