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TMFBabo (99.99)

Inflation Protection: Pay Off Variable Interest Debts!

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October 09, 2009 – Comments (6)

This is much more personal finance strategy than investment strategy, but I came to this realization recently and thought it good to share it.  I'm sure many of us struggle with whether we should pay off debts or invest.  Most of us are not filthy rich, so we must often choose whether to pay down debts or invest the little extra free cash flow that we have. 

If you've seen any money supply charts recently, the recent money expansion is disgusting.  We have yet to see those effects, but the potential is there.  Just as recently as 2007, when inflation wasn't crazy, I had one private student loan in particular that was as high as 8.75%.  It's currently sitting at 3.25%, but even modest inflation would push it way higher again.  

I look at TIP, which currently yields 3.84%.  This is not much higher than my student loan.  TIP would obviously yield more if inflation went up, but my student loan rate would also go way up.   For now, I'm going to assume that the tax disadvantages of TIP (capital gains!) and tax disadvantages of paying off a student loan early somewhat cancel out.

What is the allure of TIPS? It's mainly the idea of guaranteed yield, right? Even if inflation goes up, you do get a degree of protection as the interest rate gets readjusted periodically.  I believe that paying off any variable interest debt is more appealing.  Even with my currently low private student loan, paying it off is like inflation protection.  The rate will go way up if inflation hits, so any money sent there is sorta like buying TIPS, except that you get the added psychological bonus of paying off debts.

The choice is much more obvious with my 7.9% Bank of America card.  It was a fixed rate for a long time until a few months ago, when Bank of America finally screwed me by making the rate variable (No, I wasn't surprised).  Until recently, I was content investing extra cash flow instead of sending it to my 7.9% card, since I believe I can beat  7.9% with my investments.  Now that the rate has turned variable, I will strongly consider sending a chunk of extra FCF to this particular debt instead.  

Basically, here's my new investment/debt repayment pecking order:
1. Invest in tax-deferred investment accounts
2. Pay off variable interest debt
3. Invest in taxable accounts
4. Pay off fixed interest debt

Thoughts? I'm sure some of you do this already.

6 Comments – Post Your Own

#1) On October 09, 2009 at 6:11 AM, MDGiz (< 20) wrote:

This has always been a debate among friends and family, luckily my wife knows I am better with investment decisions.

I had student loans in the early 90's, I actually consolidated my loans.  made one payment to one company and the money I saved I invested.  I have been invested ever since, only taking a year off or so because of a new baby.

As far as taxable accounts...I would rather stick to high paying dividend funds. If for some reason I find I need to offset capitial gains I am always sitting on some losses I can sell.

As far as how I get the money even though I am several hundred thousand in debt and make less than $75K a year now that my wife doesnt work?  I have 2 houses and I am lucky to be renting those.  Location, location, location right? Well my interest rate in at 5 1/4, not bad, I could pay off one of the mortgages with the money I have in the market but why?  If my annualized returns are greater in stock why not keep it in stocks?  Same with cars, although I have only bought one new car (w/mutual fund profits), if you make more in the market why not keep a 3.9% loan rolling and put your extra money in where you can.  Ok, now I know this doesnt work for everyone, and many people dont know where the market is going, but there is money to be made, even in a down trend. Stick to basic fundamentals and dollar cost average when you can instead of lump summing money unless you know its at the bottom and most of us dont.

MHO,

Giz

 

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#2) On October 09, 2009 at 11:39 AM, TMFBabo (99.99) wrote:

Giz, I wish you market-crushing returns.  Of course it's different for everyone, but I agree with you on your decision to invest the money. 

I guess I was trying to point out that a variable interest rate has the potential to burn you badly if inflation and higher interest rates decide to happen.  While I'm not willing to buy TIPS instead of stocks, I am indeed willing to pay off variable rate debts with some of my money since it's both inflation protection AND debt reduction. 

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#3) On October 09, 2009 at 7:57 PM, zebrafooler (< 20) wrote:

You have to pay taxes on money you make .  You don't pay any taxes on money you save.

If you pay off your debt and save 10 bucks on interest it all goes in your pocket.  If you make 10 bucks in the market only 7 or 8 goes in your pocket after Uncle Sam takes his cut. 

So you have to actually do better than your credit card rate to break even.

 

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#4) On October 12, 2009 at 6:15 AM, CaptBS (29.63) wrote:

That prioritization makes sense if you're only considering interest rates on debt versus returns on investments... but what about your credit rating and history?

If you funnel free cash toward investment accounts before paying off a revolving line of credit (such as a credit card), and you aren't paying off the balance in full each billing cycle, then over time, that balance is going to increase. Eventually, that balance is going to occupy a significant percentage of your total credit limit, and your credit rating will start to take a hit as a result. Consequently, future lines of credit that you may open will carry higher interest rates (or your creditor may decide to change your terms, as Bank of America did for you), which raises the bar for your investments to outperform, and effectively increases your exposure to market downturns.

Perhaps I'm taking your approach to a logical extreme (carrying a relatively small balance that is occasionally paid down with additional cash as it becomes available or as market conditions dictate might be manageable), but at least to me, it seems like this is a dangerous cycle to initiate. If the end goal is to create additional buying power (leverage) for your investment accounts, what's the difference between investing before paying off revolving debt and trading on margin*?

(*Or are we just talking about extending the margin that your brokerage has already afforded you. :-) )

Curious for your thoughts. Apologies if I've misunderstood the gist of your question. (The sunrise is telling me that I should have been in bed a long time ago...)

 

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#5) On October 12, 2009 at 1:38 PM, TMFBabo (99.99) wrote:

@CaptBS: In real life, I use a card with no balance on it and pay it in full every month.  The Bank of America card's balance will go down even if I pay only minimum, since I don't use it anymore. 

I guess I just made myself aware of the potential for variable interest rate debt to act sort of like a debt reduction version of TIPS. 

My 401k allows for individual stock picking, so it is essentially a much bigger second IRA.  Just trying to max the 401k and my Roth IRA is quite an ordeal, so I haven't been aggressively following what I wrote in my own blog post.  Item #1 takes up most of my cash flow available for debt repayment/investing.

Assuming I have any cash left over, I'm likely to pay down variable interest debt and also have some taxable investments thrown in for good measure.  The only thing I don't do at the moment is pay down fixed debts early.

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#6) On October 14, 2009 at 1:17 PM, CaptBS (29.63) wrote:

Wow, I wish I had a 401k that worked like that. I can definitely see why item #1 would take up a lot of free cash in practice (all I have is an IRA, and the contribution gets maxed out pretty quickly).

At any rate, it's an intriguing idea. I can't say that I've ever thought of managing debt like this as a way of hedging against inflation, but if we were ever to return to anything resembling the rates that we saw in the 70s, it might look like a brilliant move in retrospect.

I guess it's sort of similar to opening a CD ladder when you suspect that an extended expansion period is about to end and interest rates are high, then allowing the rungs to fall back into cash (and your investment portfolio) after the economy contracts and rates fall precipitously. I started doing this in late 2007 with some funds that I wanted to use for a down payment on a house within 2-3 years and it's worked out nicely.

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