Paying Off Loans May Be Better Idea Than Saving
The Federal Reserve’s latest interest rate cut, some financial planners say, sends a compelling message to consumers: Pay off your loans.
Counterintuitive? Sure. It’s relatively cheap to borrow today. However, it can be relatively expensive to save. That’s because savings rates on popular short-term accounts have dipped below the rate of inflation, particularly if you consider the after-tax return.
Translation: Every dollar you save in a low-rate, low-risk account actually cuts your spending power.
On the other hand, using discretionary income to pay off loans boosts your spending power today and in the future, and provides a relatively generous, risk-free return, financial advisors say.
“It is absolutely the time to get rid of debt,” said Janet Briaud, certified financial planner with Briaud Financial Planning in Bryan, Texas. “I think we’re in a deflationary environment, and in that kind of environment you get more out of paying off your loans than you get from saving.”
Paying off debts even could prove more lucrative than contributing to some tax-deferred retirement plans, Briaud added. Those who don’t get the benefit of company matching contributions, for instance, would be better off paying off a credit card loan than contributing to a 401(k) or 403(b) plan, given today’s diminished investment prospects, she said.
Credit card debts carry exceptionally high costs, and interest paid on them isn’t tax deductible.
The same argument would not hold, however, if you were contemplating paying off a lower-cost home mortgage loan versus contributing to a retirement plan, she noted.
Also, investors who are confident they can earn high returns on stocks in the next few years may argue the market is the best place for their money.
Still, there’s simply no debate for those who are considering saving in a money market account versus paying off a loan, experts maintain.
“Savings yields are at an all-time low,” said Greg McBride, financial analyst with BankRate.com, an interest rate tracking firm headquartered in North Palm Beach, Fla. “There is no sense having cash sitting in a low-yielding savings account that could be used to retire higher-rate debt.”
Despite the weak economy, paying off loans should take higher priority even than funding emergency savings, some planners said.
Why? If you’re concerned about your ability to keep your job, you’d be well served to find ways to cut expenses, said Margie Mullen, a fee-only financial planner in Los Angeles.
One very effective way to cut costs is to pay off or reduce your loans, advisors say. “If your cars and your home are paid off, if worse comes to worse, you can plant vegetables in your backyard” and in general live on much lower income, Briaud said.
Moreover, you can tap credit cards to pay expenses in an emergency, she noted. But every day that you have both a loan balance and money in a low-yielding savings account leaves you poorer.
To some degree that has always been true, experts say. However, usually you can at least keep pace with inflation--after tax--by saving in bank certificates of deposit, for example.
Today, by contrast, inflation is averaging nearly 3%, while one-year CD yields average just 2.94%, according to BankRate.com. Worse, you pay tax on the 2.94% savings yield, which means someone in the 30% tax bracket would take home a 2.06% yield after tax--a “negative” real return, meaning after inflation.
Those who have both debts and short-term savings may be losing a fortune in purchasing power because of the huge gulf between today’s savings rates and the cost of loans, experts say.
Consider: Average rates on money market mutual funds have fallen below 2.6%; however, the average cost of credit card debt is more than 14%.
Because loans are generally paid off with after-tax income, a person in the 30% tax bracket would have to earn 20% on savings to beat the benefit of using those savings to pay off a 14% loan.
“Paying off debt has the same effect as saving, but the savings equivalent rate is at least the rate on the loan, if not more,” Mullen said. “And that’s an absolutely risk-free return.”
Consumers ought to list their debts in order--highest-cost debts first--and then make an effort to pay off each of those loans with any discretionary income they might have, Briaud added.
Remember, some debt is more onerous than other debt: Interest charges on credit card and auto loans aren’t tax deductible, but interest paid on a home mortgage and most home equity loans is. That makes home loans comparatively less expensive, after tax.
Still, after accounting for the tax benefits, a 7% home mortgage costs someone in the 30% tax bracket about 4.9%. Meanwhile, the average yield on a 5-year certificate of deposit is 4.52%, according to BankRate.com. A consumer in the 30% tax bracket would take home a 3.16% return from an account that paid 4.52%, after subtracting income taxes.
The issue of what to do with student loans is somewhat complicated, for several reasons. Only some consumers can deduct the interest they pay on these loans, so the after-tax cost will vary.
Meanwhile, student loans have relatively low rates and are highly flexible. If the borrower loses his or her job or suffers another financial hardship, for example, student-debt payments could be deferred without wreaking havoc on the borrower’s credit rating. That makes student loans--even when they’re somewhat higher-cost than other types of loans--a lower priority to pay off than less-flexible debt, planners noted.
Nonetheless, those who have the means would be wise to pay off these loans too, Briaud said.
“We’re telling our clients to get rid of all their debts--even the 7% home mortgages,” she said. “It may sound crazy, but it’s the best risk-free return you can get.”
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Falling Rates
Interest rates have fallen on a wide range of consumer loans this year, but declines in savings yields have been more dramatic.
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Interest rate Type of loan Jan. 1 Sept. 26 Variable-rate credit card 17.09% 14.12% 48-month auto loan 9.64 8.81 30-year fixed mortgage 7.07 6.70 $10,000 home equity 9.33 6.54 line of credit One-year CD (avg.) 5.33 2.94
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Note: All rates are national averages.
Source: Bankrate.com
