Thursday, March 26, 1998
by Rob Landley
Alexandria, VA (Mar. 26, 1998) -- A few weeks ago, Ram Krishnan, an engineer in Mansfield, Massachusetts, wrote this to us on the Web message board:
"In today's Cash-King Portfolio Report, Tom opined that if you have debt being serviced at 10% or more, you should avoid the market. The rationale being, the stock market has returned historically 10%.
"Even assuming that we are not in a new global era of technology-enabled productivity enhancements, if we select stocks carefully and prudently as your various portfolios have so elegantly demonstrated, returns in excess of 10% can easily be (and have been) attained. In summary, the floor that we should compare is not historical stock market returns but something like the Foolish-Four average returns."
Although I understand Ram's perspective, I disagreed with his assumptions. I even think Tom was being generous in identifying 10% debt as the standard bar. We've written and do believe that 8% is the peak level of debt individuals should carry when they go out to invest in stock. If that. Let me explain with some clear examples.
First, I see paying off debts as a way to lock down a guaranteed return. No stock is going to guarantee a return, nor will investments in real estate, nor even municipal or corporate debt. For instance, Sears went through Chapter 11 in the 1980s, and the city of Miami's credit rating today would prevent it from accessing their library card. I see paying down personal debt as the one true guarantee of investment growth.
Secondly, your payments on personal debt afford you tax-free growth. If the stock market climbs at an average annual rate of 11%, if you're a trader, you'll be paying annual taxes on your capital gains. Even if you're a long-term investor, you'll eventually return 18-20% of your investment gains back to the guv'ment. When you pay down debt, you're getting pure, tax-free growth and you should naturally attack the highest interest rates first.
Third, most people's major monthly bills are actually enduring debts. The car payment. The mortgage. Student loans. Financed furniture. Credit card bills (oof!). Once you're totally out of debt, you're halfway to retirement right there. Everything else is just cash coming in after paying down your daily living expenses -- which for many people aren't material. In Fooldom, we do love to occasionally attack bad thinking., but allow me to champion the positive spin. In Fooldom, we have literally tens of thousands of people who will be retiring early because they're saving and investing today. You don't have to wait until you're 65. Getting rid of your debts quickly is the key part of that equation.
Fourth, let me consider real estate "investments" for a second. I just bought the condominium next door to me here in Austin, Texas. As an investment, it's not likely to beat Dell stock, but I've researched it and I'm happy enough with my projected returns (Austin is growing like a small-cap). I got the condominium at an inexpensive price; it's in a great part of town; property values in Austin are chugging ahead speedily; and I can easily rent it out for far more than the monthly payment.
So I'll be accumulating principal as I deduct the operating expenses, maintenance costs, and "depreciation" off my tax statement. Not bad, but I still don't think it'll beat the rate of return of the Foolish Four or Cash-King stocks over the next decade. But I do think it'll be competitive with the market's average historical rate of return. It gives me a little bit of diversity away from my stock portfolio. And I get to learn more about real estate, my city, and my neighborhood.
However, real estate investing won't pull me away from stocks (which generally proffer better returns for a lot less work). I never would've laid money down for the condo if I didn't have several non-investment-related reasons for getting it. Here are a few others. I live right next door to the property. I get to pick my neighbors. I also know more about that particular property than anyone else (including the seller, who doesn't attend the condo-association meetings). I learn how to take care of property. I get experience as a landlord, so I know if it's something I might want to do more of in the future. And if I decide all of this is not for me, I have the option of knocking out the wall, turning the two condos into one big one, and living like a minor king.
Now, why did I bring that up... just to gloat that I think I got a good deal on a condominium?
Not entirely, no. I bring it up because I got a mortgage on the thing at a little under 8% (which isn't too bad, although the condo I live in is at 6.75%). And according to the mounds of paperwork I recently signed, if I don't pre-pay the loan, the $37,600 I financed will end up costing me something like $65,000 in interest over the thirty-year length of the loan. That's almost twice the amount of the original loan! And that doesn't even include the cost of compounding; those numbers are if the principal steadily is declining. On the whole, over the length of the deal, I might end up paying over $90,000 to eliminate under $38,000 of initial debt. Needless to say, I'm thinking of paying this off as quickly as I can -- aiming for five years of hard work to get me there.
Now, 8% is a pretty good interest rate, historically speaking. If you're like most people, your mortgage probably is not your highest-rate debt. My car loan -- a 3-year loan that will be paid off in November -- is at over 12%. (Hey, what can I say, I was a first-time car buyer. They smelled blood the moment I walked in the door. They got me for the extended warranty and everything. I wish the Motley Fool's "How to Buy a Car" area had been around for me then.) In just three years, I've ended up paying half the car's price over again in interest. Ouch. If a 12% car loan hits that hard, imagine what 17% credit cards are doing to you -- and then remember that the average American carries credit card debt at 18.5% per year.
Fools, I've found that debt makes it hard to track my real, pure investment gains. Debt hanging around at 12% turns a 15% investment gain (which is a market-smashing rate of return) into a 3% rate of return. And that just about breaks even with historical rates of inflation, which means you get nothing for smashing the market. And then what happens when you pay capital gains taxes of 20-28% on that 15% growth? You end up losing to inflation. You end up losing value over time.
This is the reason that your Cash-King managers advise against investing if you're borrowing money at interest rates exceeding 8% per year. Frankly, I'd prefer to concentrate my efforts primarily on paying down debts even below that rate. And I'm factoring in the deductibility of mortgage payments. Certainly, each individual has to bake in all the costs and benefits, and then make his own decision.
For me, debt repayment is guaranteed growth; I don't have to invest any time on research, as I do with stocks; the repayment represents tax-free growth; and once I've eliminated it, I can start dreaming about what my life will be like when I'm 50-years-old maybe writing a book on how to build sand castles on the French Riviera (if I'd ever do such a thing).
Whatever it is, it'll be my option.
Rob Landley, Fool
Stock Change Bid ---------------- CHV -1 5/8 83.81 KO + 3/16 76.19 EK - 5/8 63.75 XON - 5/8 67.88 GM -1 1/8 69.38 INTC +1 11/16 76.06 MSFT +3 15/16 88.81 PFE - 3/4 94.50 TROW -1 1/4 69.25
Day Month Year History C-K +0.08% 1.29% 3.08% 3.08% S&P: -0.34% 5.01% 10.05% 10.05% NASDAQ: +0.67% 3.05% 10.38% 10.38% Rec'd # Security In At Now Change 2/3/98 22 Pfizer 82.30 94.50 14.83% 2/3/98 24 Microsoft 78.27 88.81 13.47% 2/27/98 27 Coca-Cola 69.11 76.19 10.25% 3/12/98 20 Exxon 64.34 67.88 5.50% 2/6/98 28 T. Rowe Pr 67.35 69.25 2.83% 3/12/98 20 Eastman Ko 63.15 63.75 0.95% 3/12/98 15 Chevron 83.34 83.81 0.56% 3/12/98 17 General Mo 72.41 69.38 -4.19% 2/13/98 22 Intel 84.67 76.06 -10.17% Rec'd # Security In At Value Change 2/3/98 22 Pfizer 1810.58 2079.00 $268.42 2/3/98 24 Microsoft 1878.45 2131.50 $253.05 2/27/98 27 Coca-Cola 1865.89 2057.06 $191.17 3/12/98 20 Exxon 1286.70 1357.50 $70.80 2/6/98 28 T. Rowe Pr 1885.70 1939.00 $53.30 3/12/98 20 Eastman Ko 1262.95 1275.00 $12.05 3/12/98 15 Chevron 1250.14 1257.19 $7.05 3/12/98 17 General Mo 1230.89 1179.38 -$51.52 2/13/98 22 Intel 1862.83 1673.38 -$189.46 CASH $5666.26 TOTAL $20615.26 *The year for the S&P and Nasdaq will be as of 02/03/98