Author Topic: Is paying off a debt equivalent to investing in bonds?  (Read 5827 times)

Allen

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Is paying off a debt equivalent to investing in bonds?
« on: January 27, 2014, 03:59:28 PM »
Lets say you have a student loan at 4.88% with 20 years of payments left.

If you have $1,000 extra a month, and you invest $800 in an Index fund, and $200 extra paid on the student loan, is the equivalent for risk purposes as an 80/20 Stock/Bond allocation for your investments? 

Sorry for the beginner question, but that scenario seems equivalent to me as $800 into an index fund and $200 into a bond index fund as far as returns.  At the end of the loan payoff I don't 'own anything' though, so I don't know if that changes the math.

Please forgive (but answer) my question.

Cyrano

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #1 on: January 27, 2014, 05:13:51 PM »
No, for a few reasons.

1. Taxes. The bond investment pays you income that you pay taxes on. The debt interest saved is somewhat different, depending on whether the interest is tax deductible.

2. Liquidity. If you want or need to sell part of the bond investment, for example to rebalance into stocks after a stock market downturn, you can.

3. Bond funds are not bonds. An investment grade bond pays a certain interest income for a certain time, and is somewhat comparable to a lack of debt in that respect. A bond fund pays a dividend (or not) based on the success of the fund's investments in the bond market, and that fluctuates according to the interest rate and other market fluctuations.

jawisco

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #2 on: January 27, 2014, 08:04:57 PM »
Paying off debt is the equivalent to investing in bonds in that you get a guaranteed rate of return for your "investment".   

Your return on investment for your $200/month is 4.88%.  I don't think student loan interest is tax deductible, so you are almost certainly better off paying off the loan rather than investing in a bond fund or individual bonds. 

If I had that debt, I think I would take the sure thing and pay that off asap with as much after-tax money as possible for that kind of guaranteed return, at least after you maxed out your 401K and other tax deferred opportunities.  Other folks will disagree, but I don't trust the stock market as much as they do...

Jack

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #3 on: January 27, 2014, 08:37:06 PM »
I don't think student loan interest is tax deductible

Up to $2500/year of it is.

Despite the differences Cyrano mentioned, I treat debt paydown as the "bond-like" part of my asset allocation.

Richard3

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #4 on: January 27, 2014, 11:23:28 PM »
Debt is like fixed interest but it offers returns of whatever interest rate you are paying with absolutely zero risk. This often means that the expected return is more attractive than investing in stocks.

US inflation is 1.5% according to a rudimentary Google. This means you're getting 3.38% real return on paying off your debt (ignoring tax deductions for now but if you get them they effectively reduce your interest rate). Stocks probably pay more than 3.38% in the long run, so unless there are liquidity or credit score reasons, I think your 80/20 idea is fine.

One thing to think about is whether that 4.88% is fixed or not. If it is fixed at 4.88% for significant time then I would not pay it down any faster than required to stay out of default (if interest rates / inflation rise you are effectively getting PAID to have that loan). If it is a floating rate then I'd treat it as my bond allocation.




dmn

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #5 on: January 28, 2014, 12:36:27 AM »
One thing to think about is whether that 4.88% is fixed or not. If it is fixed at 4.88% for significant time then I would not pay it down any faster than required to stay out of default (if interest rates / inflation rise you are effectively getting PAID to have that loan). If it is a floating rate then I'd treat it as my bond allocation.

If the interest rate is fixed, you can treat is as a long-duration bond. As even 30 year bonds yield less than 4% right now, paying down debt is a superior replacement for bond investments even if the interest rate is fixed at 4.88%.

If bond yields rise above 4.88%, then it might make sense to invest new contributions in bonds instead, but before that, paying down the loan is better. (The threshold may change due to tax reasons, I am not familiar with the US tax system.)
« Last Edit: January 28, 2014, 12:41:11 AM by dmn »

Khan

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #6 on: January 28, 2014, 02:02:35 AM »
I thought I'd come in at the other side of this.

The stock market is -not- guarenteed. Over history, averaging things out, you get between 7-9% return yearly over the last 80-120 years(depending on the study).

However, your returns from paying off your student loans -are- guarenteed. At 4.8% interest, it's not the 6% or above where I'd happily tell people -not- to invest, but it is a pretty substantial payoff(guarenteed). It removes the stranglehold on your future(you will have to pay these loans back sometime), it provides you financial freedom, and it might make you feel a lot better too, which is incredibly important for your long term financial health, being happy with what you're doing.

I'd consider prioritizing tax advantaged accounts(because you never get the chance to up past contributions once the FY is over) and debt over investing elsewhere, with a bit of thought on whether you'd feel better pushing that debt off sooner rather then later.

Richard3

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #7 on: January 28, 2014, 01:38:46 PM »
One thing to think about is whether that 4.88% is fixed or not. If it is fixed at 4.88% for significant time then I would not pay it down any faster than required to stay out of default (if interest rates / inflation rise you are effectively getting PAID to have that loan). If it is a floating rate then I'd treat it as my bond allocation.

If the interest rate is fixed, you can treat is as a long-duration bond. As even 30 year bonds yield less than 4% right now, paying down debt is a superior replacement for bond investments even if the interest rate is fixed at 4.88%.

If bond yields rise above 4.88%, then it might make sense to invest new contributions in bonds instead, but before that, paying down the loan is better. (The threshold may change due to tax reasons, I am not familiar with the US tax system.)


I'd probably pay down a variable rate debt at 4.88% with my bond allocation before buying a bond at 4% (although if I was able to write the interest off against my income at a 20% tax rate, I wouldn't because then I'm only really paying ~4% interest).

But if the rate was fixed at 4,88% I probably wouldn't pay it back faster than needed, especially at the cost of maxing out tax-advantaged investments, because it's an asymetrical risk situation. If when interest rates rise, I'm on the right side of the spread and at the moment I'm not badly on the wrong side (especially after figuring in taxes) and it's not going to get much worse.


dmn

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #8 on: January 29, 2014, 03:30:56 AM »
But if the rate was fixed at 4,88% I probably wouldn't pay it back faster than needed, especially at the cost of maxing out tax-advantaged investments, because it's an asymetrical risk situation. If when interest rates rise, I'm on the right side of the spread and at the moment I'm not badly on the wrong side (especially after figuring in taxes) and it's not going to get much worse.

If I understand you correctly, you basically agree that paying back the debt is a superior equivalent to a bond investment, but you would not invest because you prefer a 0% bond allocation right now? That's fine if you are tolerant to high levels of risk, but the question was whether paying down the debt was a good idea given that Allen wants to have a 20% bond allocation.

Richard3

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #9 on: January 29, 2014, 03:49:11 PM »
My point wasn't about asset allocation, it was about the importance of fixed vs floating rates.

If the interest rate on the debt is floating (or is reset frequently - like annually or less) then one would pay down the debt with whatever one's bond allocation was. This is because there is no benefit to having the debt if rates go up. If interest rate on the debt goes down it may cease being worthwhile to repay but unless you want to gamble that interest rates will fall (and there are better ways to do that) you pay off the debt because it's better to do it now.

If the debt is fixed for a longish term - five years maybe - then I would not pay down the debt faster than required to avoid default. This is because there is a benefit to having the debt if interest rates rise - you are borrowing money at 4.88% and now able to end it out at 7% say. You will not be able to borrow new money at 4.88% in this high interest rate future so this opportunity is lost to you if you paid the loan off. If interest rates fall, you then pay the loan off as fast as possible because it is suddenly a great investment (4.88% vs 2% lets say).

So, in summary, if paying off debt is currently equal or marginally better than buying bonds, I'd buy bonds with if I had a fixed rate debt and pay off if it was a floating rate debt.

letro

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #10 on: January 29, 2014, 07:23:20 PM »
Possible forgiveness of student loans in the next couple of years as a way to stimulate the economy. This idea comes from the financial intelligence report interview with Russell Napier January 2014.  Suggestion enjoy your youth and every day of your life. Many activities are only available at certain ages enjoy now.  Make an enjoyment plan and savings plan. Max out 401K and/or IRA, if you and family agree on this level of savings. Pay the student loan each month. Keep smiling Letro

CanuckExpat

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #11 on: January 29, 2014, 11:17:53 PM »
There's some more discussion of this general topic here: http://www.bogleheads.org/forum/viewtopic.php?t=11861

Thegoblinchief

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Re: Is paying off a debt equivalent to investing in bonds?
« Reply #12 on: February 01, 2014, 06:57:10 AM »
Good arguments on both sides. Here's how I'd break it down:

1. 4.8% is boderline when it comes to guaranteed return by paying debt, and taking the risk for greater reward in stock market.

2. Is it fixed or variable? If fixed, see #3. If variable, that rate WILL go up. Start paying it down now.

3. Is your retirement target longer than 10 years away? Over 10 years, you have a very good chance of earning more than 4.8% in the market. At least 1-2% more annually, after inflation, possibly quite a bit more.

The bulk of my own debt is at 6.5%, so I'm throwing everything extra at that. If mine were at below 5%, though, I'd be paying at the normal schedule, maxing my Roth, and then building my taxable portfolio since my target retirement date is 15 years away.