Invest or Tackle Debt with New Money?

You have just come into some new money from the sale of a business, an inheritance or just a big commission check. Regardless of the scenario, new money is the seed of your future, and you find yourself pondering what financial field to plant it in. Given today’s wonky capital markets, rising interest rates and recession predictions, do you go risk-off and pay down debt or lean into lower stock and bond prices?

There are four basic things you can do with new money. Spend it, save it, pay off debt or give to charity.  All of us must spend a certain amount to live, and charity is very much a personal choice. The focus of this article is whether to invest or tackle mortgage debt. Both are good choices, but is it one or the another?  If you search online for answers, you will see a lot of commentary that pits one option against the other and the basis of the argument is the math. There are three fundamental issues with this simplistic approach. It does not begin with an end goal in mind, it ignores human behaviour, and it is based on financial inputs that are very hard to predict.

Every investor is different. Looking down the road, what do you want to achieve? Here is where an advisor can be a great coach! Like writer and educator Steven Covey outlined in his teachings, “Begin with the end in mind”.  If having a mortgage-free lifestyle is more critical to you, then paying it down is a solid choice.  Just also look at the other implications, that you may be over invested in real estate down the road or lack retirement funding. If you don’t need the bragging rights of owning your own home and would rather rent and invest than you can do very well.  Just recognize you will be exposed to rent increases and potential moving disruptions if your landlord decides to sell. For most, beginning with the end in mind will likely be that being both mortgage free and having sizable investments is ideal.   Allocating a percentage to both is best, it’s just a personal choice on the exact ratio.

When looking at the math of investing versus paying off debt, there are some compelling arguments for just paying off the mortgage.  Your mortgage interest rate is your risk-free return rate or hurdle rate.  Put simply, if you cannot consistently get better returns from investing that the rate of interest on your mortgage than why take the risk?  Paying off a mortgage, especially in the beginning when the principle is large is just boring and with so much going to interest it might not seem like you are accomplishing much.  Humans need progress and reward to entrench a discipline, so with so little happening the concern is that it will not be kept up.  Investing, especially in the beginning, can have better rewards to entrench the habit. Going from a zero base is a whole lot more rewarding.  Mid-career investors can get the same lift from starting a new investment within a well constructed portfolio.  If you do have a lump sum of new money or are adjusting your monthly contribution program, it probably best you allocate to both.

If you listen to enough well-respected money managers, there is a consistent message that predicting the future of interest rates is very difficult. There are so many factors such as inflation and geopolitics that go into it that even the bright minds at the central banks struggle to predict. As an individual the best we can do is admit we don’t know and assume they will land in a range, for today’s environment about 3-8 percent is a good guide. The challenge with a math-based plan of invest versus debt is the underlying interest rate drives the decision, and who knows?  Since most mortgage terms are 2-5 years, you could be switching back and forth between strategies and that is tough to manage.  

Another consideration for taking a diversified approach is hedging against future inflation. Mortgage debt for most is our cheapest debt to carry.  A healthy amount of fixed-rate mortgage debt is a cheap form of an inflation hedge.  Many investments are touted as inflation hedges; a simple example is precious metals. If rising inflation is a concern, you may not need to buy gold when holding a reasonable mortgage does the same thing. Once again, a diversified approach is best to mitigate the risks of making a math-based decision.  

Receiving new money to put to work is an exciting moment, even if is just the routine monthly contributions. It’s not the amount that counts, it is the sustainable discipline that counts. If you are a mortgage holder with pre-payment flexibility you may be increasingly looking at paying off that debt, especially in the current investment environment where putting money to work is like catching a falling knife. Simply taking a binary approach to the invest versus debt question is too simplistic. Adding to our investment portfolio when things are on sales is a great move, but so is whittling down a mortgage and reducing interest rate costs. For most, a sustainable balance of addressing both is best.

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