Debt reduction: a sound investment strategy

Healthcare Financial Management, May, 1996 by William G. Kistner

Because of last year's volatile stock market performance, the risks of equity investing in 1996 are being hotly debated. All indications are that the market is due for a correction, and the 171-point decline that occurred March 8, followed by the 110-point gain March 11, is viewed by many observers as an omen of future market swings.

Whatever the short-term outlook for stocks is, a sound investment strategy for those who have funds to commit is not an investment at all - at least not in the traditional sense. Debt reduction - paying off debt, such as a mortgage or credit card balances - provides an "investment return" equal to the interest rate charged by the credit source with no risk to the principal. Of course, those who reduce installment debt are not really receiving a return, but the net result is the same. They get farther ahead - in this case - by not paying interest rather than by paying it. Some financial planners refer to this strategy as "investing in one's balance sheet."

For example, paying off an 8 percent fixed-rate mortgage is the equivalent of earning a fixed, guaranteed 8 percent taxable return with zero risk to principal. No traditional investment vehicle is available that offers this favorable combination of risk and return.

The only investment option that offers as many guarantees is a Treasury bill. But the average yield on a 90-day T-bill currently is in the 5- percent range - about 300 basis points lower than the 8-percent fixed-rate mortgage.

Paying off credit cards

Paying off credit card balances that accumulate high-rate, nondeductible interest costs is even more attractive as an "investment strategy" than mortgage debt reduction. Few alternatives can match the after-tax "return" realized by paying off this type of debt, with average credit card interest rates currently running 18 percent and department store credit card interest rates averaging 21 percent.

For those who have an A-1 credit rating, obtaining a low-interest-rate credit card is one way to reduce this cost. Card holders can consolidate their high-interest credit card balances and reduce payments considerably. Those who pursue this option, however, must scrutinize carefully the terms of the credit card issuer. Many companies offer low, introductory "teaser" rates that are good for a short period of time and then increase sharply thereafter.

A home-equity line of credit is another vehicle for reducing consumer debt. Usually it is available quickly and enables homeowners to save on interest costs while still being able to tap their home's equity if the need arises. Home equity financing generally is offered at favorable rates, and the interest costs are tax deductible up to $100,000 of home equity debt.

Disadvantages of a debt-reduction strategy

A debt-reduction strategy has some disadvantages. One disadvantage is that reducing debt leaves less money available for other financial needs. And, in the case of a mortgage, money that otherwise would have been available for investment is being placed into an illiquid asset: Mortgagors cannot sell a portion of their home the way they could sell stocks or bonds if they needed cash. For that reason, those who commit to a mortgage-reduction plan should keep an adequate emergency cash reserve to cover unexpected expenses. If they are forced to take on high-interest-rate, short-term debt to cover emergencies, they defeat the purpose of paying down debt. To make matters worse, they may end up paying more money - because of nondeductible interest payments - than they were paying before embarking on the debt-reduction plan.

Historical rates of return on stocks

Also affecting one's decision to reduce mortgage debt are the traditionally favorable rates of return on stocks recorded from 1926 to 1995. Based on this historical information, over the long term, the average rate of return on stocks should be higher than the current mortgage rates.

Also, the risk of investing in stocks, as measured by variability of returns, decreases as holding periods increase. Standard deviation, which measures how much returns fluctuate, drops sharply from a one-year holding period when compared to 10 or 20-year holding periods. Therefore, for long-term investors, paying off a mortgage might not compare as favorably with investing in stocks.

Ultimately, the decision of whether to invest funds or to use them to pay off debt requires careful analysis of one's short-term and long-term goals, liquidity needs, and tolerance for risk.

William G. Kistner, CPA, is a tax partner with Ernst & Young LLP, Chicago, Illinois. Readers' comments and questions should be addressed to him at Ernst & Young LLP, 233 S. Wacker Drive, Chicago, Illinois, 60606-6301.