Friday, September 10, 2010

Alternative Investments: Paying Down Debt

I might sound a lot like Dave Ramsey with this post, but I will try to bring up a few ideas that will help any investor make a pretty good Return on Investment without purchasing any securities.

So, the S&P 500 ended 2009 at a value of 1,115.10. Yesterday the same index closed with a value of 1,104.18. So, if we plug those numbers into a cute little equation ((1104.18-1115.10)/1115.1)=-0.97%, we see that it has lost almost 1% of its value in nine months. So what, right? Well, what about a buy-and-hold strategy, brokers always say that works better? hmm, the S&P closed at 1,502.51 on 09/07/2000 (ten years ago, yesterday) So, we pull out our cute equation and see ((1104.18-1502.51)/1502.51)=-26.51%, So, if you bought stock in January this year, you'd be losing money. If you bought stocks in 2000, you'd be losing tons of money.

I'm not saying that you can't make money in the market, simply that you have to be active in your management style. If you are smart or lucky you can outperform the market. It is just hard to do, especially if you have a full-time day job (lame) and you can't watch the markets all the time. So what do you do?

Well, take a look at your credit card statement. What is your interest rate? 10%, 15%, 25%? If you have a fairly low balance, you probably aren't paying a lot, in absolute dollar terms. However, a 15% expense is still a loss that you should try to avoid. So, pay off those little debts that have high interest rates, now! Forget about the Netflix (NFLX), and your fast food (MCD) spending until you have paid off the consumer debt. It will save you a TON of money in the long run!

Next, look at other debt - like student loans, vehicles, boats, signature loans, etc. The rates on these things tend to be less than credit cards, so, they won't be killing you too quickly. You still need to focus quickly on getting rid of the debt. Just one dollar at a time if you have to. One of my professors told me that he is still paying down his student loans! Based on how long he has been around, he has probably paid thousands in interest on those dumb things. He claims that the interest rate is only a few hundred basis points (trying to sound smart), so it doesn't matter. Well, the bank is currently paying like five basis points on your savings and your 401k is down 2,600, so - he is losing like 2,795 basis points on the deal. The moral of the story is: don't fall for the common misconception that small amounts of debt, or low interest rates, are okay because it doesn't make a big difference.

Next on the list is the mortgage. A mortgage is the biggest investment that most Americans will ever make. I think this is area of investing has got the most misconceptions and bad theories of all the facets of investing. So, don't get stuck into thinking that your home will always continue to increase in value, that you will be able to sell if you need to access your equity, or that paying interest on a mortgage is something that has to be done. I will try to show you how much you can save by paying a few bucks a month extra on your mortgage. (stay tuned for an excel workbook that will help with this).

Let's say that your loan was for $200,000 for 30 years and you are lucky enough to have gotten a 6% interest rate. This is probably what a lot of refinanced loans are looking like right now. Your payment will be $1,199.10 per month. As you begin to pay the mortgage off, you start by paying a large percentage of the interest first. Only $199.10 of your first payment will go toward the principal of the loan! ouch! What I recommend is that you take a look at what happens when you make intermediate balloon payments, or simply pay down a few dollars per month on the loan. The caveat is that your lender may not allow this. If he doesn't, find a new lender that will allow it!

Let's say that you get a nice bonus one year, or you win a small lottery, and you have an extra $10,000 to spend. Now, what happens if you make a $10,000 payment on your mortgage that has 25 years left to maturity. The first thing this balloon payment would do is reduce the term of your loan by 30 months! The second thing it would do is save you $27,679.06 in total interest paid!!! So is it worth it? You bet. Another thing that you might think about is making the $10,000 balloon payment, then readjusting your payment. This would lower your monthly payment from $1,200 to $1,159.81, or a savings of $40.19. This might not look like a lot, but a bird in the hand is worth two in the bush! There are a lot of things that you can do with your extra $40, like pay off your other consumer debt. So, maybe you should think long and hard about spending that annual tax return that you get! If you don't need the cash to survive, start paying down the debt!

Now we'll try another scenario. Let's say you give up your Starbucks habit and you decide that you can save $100 a month. If you pay that extra money toward the mortgage, starting five years into the deal, you will be surprised what happens to your loan.

Your new payment will be $1,299.10. This will send an extra $100 toward your loan's principal, and it will reduce the term of the loan by 65 months, or over 5 years! In terms of interest saved, you will keep $49,138.41 in your wallet and out of your banker's!

So, don't assume that the inability to make large balloon payments is a reason not to pay down the debt. Find a way to make small extra payments every month, and you will see the interest expense shrink and the length of the loan shorten dramatically!

In terms of Return on Investment, this is one of the safest, surest ways to save money. The other nice thing is that you are not subject to the pain and agony of market fluctuations. Now, when the market turns around and you can go back to expecting a return of more than 6 or 7 percent on your investments, you should probably start contributing to your retirement fund again. But until then, the best game in town is debt elimination!

Wow, this is a really long post! I dare you to read the whole thing!

1 comment:

  1. Very good advice! I even read the entire thing :) You'll have to help us figure out what to do when we finish school; it's not too far off!

    ReplyDelete