ACADEMICS TALK about the risk-free rate—the return we can earn while taking virtually no risk. In the academic literature, the yield on Treasury bonds is typically deemed to be the risk-free rate. But for many families, the risk-free rate will be the interest rate on the highest-cost debt they have. After all, by paying down that debt, we effectively earn a rate of return equal to the interest rate that we’re getting charged—and we can do so without taking any risk.
Should we go for this risk-free rate—or should we invest our extra money instead? As we weigh this decision, we should ponder two crucial questions.
First, what’s the alternative? Over the long haul, buying stocks should deliver a higher return than paying off debt, unless that debt happens to be high-cost credit card debt. But stocks, of course, also involve greater risk. If you pay down a 4% auto loan, your return is a guaranteed 4%. But if you buy stocks, your return this year and next could be far lower—and there’s a chance you’ll lose money. Still, for those with a long time horizon and the tenacity to stick with stocks when markets turn rough, a diversified stock portfolio should prove more lucrative.
What if the alternative to paying down debt is to buy bonds? As explained elsewhere, our debts are effectively negative bonds—and repaying the money we’ve borrowed will typically earn us a better return than buying high-quality bonds, because the interest rate on our debts almost always exceeds the yield on those bonds. That’s usually true even of mortgage debt, where the interest is potentially tax-deductible.
But even if paying down debt looks like the better investment, we should wrestle with a second question: What if we suddenly need cash? Let’s say we lose our job or we need to replace the roof. If we just paid off the credit cards, we could run up the balance again. But if, say, we had used our spare cash to make extra-principal payments on our mortgage or to pay off a chunk of our auto loan, we may find ourselves scrambling to raise money. Our debt repayments might have strengthened our family balance sheet, but it also may have put our spare cash beyond our reach. What to do? As a precaution, consider setting up a home equity line of credit as a backup source of emergency money.
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