Paying Down Debt
As I type this, I carry a mortgage at 6.25% and a student loan at 5.6%. Since late 2008, the proper capital allocation decision in my eyes has been to invest my free cash instead of paying down those debts. Thus far, it has been the right decision.
However, I feel differently now. I don't think rock bottom interest rates, high commodity prices, excess housing inventory, high unemployment, and low consumer confidence are the stuff of bull markets. I'm not calling for an outright crash, but I feel that it'd be tough for the markets to have a sustained multi-year rally from where we stand right now with the S&P 500 at 1271.
As a result, it wouldn't surprise me for the market to go up or down 10% to 20% for the next year or two. I believe we deserve to go down more than we deserve to go up, but my belief has nothing to do with future stock market performance.
Due to this uncertainty, I am very close to sending most of my free cash towards my debts for a while. Since my 6.25% and 5.6% debts are paid with after-tax money, I view them as equal to earning 8.3% or 7.5% in the stock market (assuming 25% short-term capital gains equal to income tax). I know there are deductions for interest on mortgages and student loans, but not paying them off because I want to deduct more from my income is like spending a dollar to save 10 cents - you still lose out. It's not that simple and the deductions are beneficial to me, but I prefer not to factor it into my decisions.
Anyway, paying down my debt would earn me a guaranteed 7.5% to 8.3% return on my money. Given the uncertainty in the market, that seems like a much better deal than at other points in the past 3 years. I'm not very confident that the market will return a guaranteed 8.3% for the next few years, so it would finally seem that the debt repayment is a viable strategy for my free cash.
Here are a few things to keep in mind:
1. This is only free cash flow I'm talking about (which at the time is not much). The rest of my assets will remain in carefully selected stocks/options/ready-to-deploy-cash.
2. Paying down the mortgage is a fairly high priority in my life right now, so there is that added incentive on top of the guaranteed 8.3% pre-tax equivalent return.
3. I really, really hate debt. I carry a pretty big amount of it though, because I have favored investing over paying down extra principal for a long time.
4. I carry some energy stocks as a hedge against inflation. These stocks shouldn't move as well as gold/silver in the face of inflation, but should still do pretty well. My debt repayment would result in negative real returns if ugly inflation reared its head, but the debt repayment would be so small compared to my investable assets that I don't think I'll be crying over it.
Just typing these thoughts out have helped me solidify my decision. Anyone employing a similar strategy? I'd love to hear your thoughts.