Reducing Debt Has Real Payoff

Who has the most powerful, smartest, hardest-working and most valuable dollars?

We do.

As more Americans concentrate on investment dollars, comparing returns of their mutual funds and debating the prospects of hot stocks, even more lose sight of the most important verity in personal finance: How we spend our money is at least as important as how we invest it.

Indeed, if paying off debt meant not having any money in stocks during the strong bull market of recent years, it still would have been a great investment. But Americans are not paying off much debt. In the last three years, consumer installment debt has expanded by $400 billion, a 50% increase.

Consider a simple test: Compare investment returns to paying off a standard credit card interest rate loan costing 18% annually.

Of the 7,216 mutual funds that were in operation at the beginning of 1996, how many do you think provided an 18% return or better? Exactly 1,803, according to fund-tracker Morningstar. And that’s a big number because it was a good year.

Now let’s make it a bit more difficult. How many do you think provided an 18% return, or better, for five consecutive years?

One. (Fidelity Select Computers.)

And no fund has been able to produce an 18% or better return for more than seven years in a row. In other words, in an entire universe of funds that can invest in anything, anywhere, not one has been able to earn 18%, year in and year out, the way paying off a bank credit card does.

The dollar in our wallet that pays off that debt is a very powerful dollar. If you are in the 28% tax bracket, you would have to invest that dollar and earn 25% before taxes, every year, just to pay the 18% interest, after taxes.

How many mutual funds can do that more than two years in a row? None.

By simply using dollars to reduce debt, most people can enjoy the level of returns usually associated with such names as Peter Lynch, Warren Buffett, Michael Price, Robert Rodriquez and Bill Sams.

The only common way to do better than 18% would be if your company has a program that matches your savings. Otherwise, it is hard to beat paying off debt.

What about your other loans? If you think the stock market won’t continue double-digit returns in the next few years, compare that prospect with paying off less-expensive debt:

* Car loans. With auto loans now costing 9.5% or more, consumers literally trade a great deal of their working lives to support auto debt. With gross average hourly earnings of $12.14, the average worker now works an hour and 13 minutes to support $100 of auto debt for a year. With the cost of the average new automobile now more than $20,000, the same worker would need to work more than six weeks a year just to pay the interest on an average car loan. Borrow less and pay it back faster and you’ll spend less of your life supporting a car.

* Mortgages. With a rising standard deduction and mortgage rates at about 7.5%, the millions of Americans who live in older or modest homes with smaller mortgages would have to earn a pretax yield of 8.82% if they were in the 15% tax bracket to cover the interest.

Although real estate advertisements regularly proclaim that mortgage rates are now reasonable, the blunt fact is that most people can’t find a fixed-income investment that will earn what they pay on our home loans.

In a universe of 3,700 fixed-income funds of all kinds, only 149 offer a yield of 7.5% and only 55 offer a yield of 8.82%. How do they earn that much? By investing in high-risk junk bonds or foreign debt. If you are in the 28% tax bracket, the required yield is 10.42%. Only two fixed-income funds offer such a return, both junk bond funds.

Meanwhile, the average person has a sure thing simply by putting that dollar into their next mortgage payment.

* Money not spent. Suppose you find ways to cut your spending by $1,000 a year. Because you would actually spend $1082.50, allowing for 8.25% sales tax, you’d have to earn $1,500 before taxes if you were in the 28% tax bracket to spend that money. If you are retired, that means every $1,000 you can avoid spending is the equivalent of having $75,000 invested in stocks that earn a 2% dividend yield, or $27,270 invested in bonds earning 5.5%. (State income taxes change these calculations slightly.)

Because the net worth of the median American family is just over $50,000 and the financial assets are significantly less than that, learning how to avoid spending $1,000 a year could be viewed as a portfolio worth more than most Americans have.

We have powerful dollars. Smart dollars. We own them. They are in our checking accounts, our savings accounts and in our pockets. A borrowed dollar is not our friend.

Scott Burns writes for Dallas Morning News. He can be reached at scott@scottburns.com, or at his Web page at https://www.scottburns.com