Should I Invest My Money Or Use It To Pay Off Debt?

First of all, let me say that if you are a holder of school debt or credit card debt, my sincerest apologies go out to you. You see, I’ve had both of these types of debt. At one point, I had racked up $12K of credit card debt by eating out way too much. And then much later on in my career I decided to get a fancy Masters degree from a private university that set me back $40,000. Student debt for millennials is a killer, especially if you received a degree in underwater basket weaving that can’t get you a high paying job.. But that is a whole different discussion for another day (or rather, article).

But this brings us to an important question. Should you use your income and savings to pay off debt, or invest it instead? Like most questions in life, it depends…

Let’s look at credit card debt by itself. Credit cards these days charge at least 15% interest rate but usually are in the 20-something percent range. And if you miss a payment, the interest goes to an even higher rate. You would have to make a return greater than 15% to make sense for you to invest. This is nearly impossible. You won’t find any investment that gives you 15% to 20% a year.

Student loans are usually in the tens of thousands and are usually around 5%. As holders of school debt know it is very difficult to get rid of student loans via bankruptcy. Remember, filing for bankruptcy destroys your credit score. If you don’t pay your loan within 9 months, the government has the power to garnish your wages and intercept any tax returns that were coming your way.

So the question is what is the best use of your money: Which debt should you pay off first? Should you invest? Theoretically speaking, if your return is higher than your interest rate it makes sense to invest the money. But if your interest rate is higher, then pay off the debt. This is a simplified answer and doesn’t apply to every person. If you pay off the debt then the monthly payment you were making will cease. In a way, that is money back into your bank account. You can put that monthly amount into investing.

I am a single track mind guy and so that means I like to focus on one task and do it really well. I would target the highest interest rate debt and pay it off aggressively. You still want to make minimum payments on the other debts because you know what happens to your credit score when you don’t. I would also pause any IRA or 401k contributions temporarily and divert that money towards the debt.

If you have enough savings to get rid of the debt then please do so. Whatever you pay off is money back in your pocket immediately. If you have $150/month of credit card debt, and $400/month of school debt (like I did), that’s $550/month you can put back into your savings, or even invest it. Paying off debt also brings freedom, motivation and a peace of mind which should never be underestimated. It’s like you have a fresh start.

I am hoping that you have an emergency fund stashed away in case you lose your job or something disastrous happens. It would be wise to build this fund up especially if you are holding debt with low interest rate. Once you have a few months of emergency savings, you can aggressively start allocating money to pay off the toxic school or credit card debt.

Paying off debt is really about choosing a philosophy as much as it is about math and interest rates. For most of us, retirement is really far away, so it doesn’t make sense to pump money into your IRA or 401K if you are sitting on credit card debt at 24% APR.

So just a recap: Assess your situation. There are no rights and wrongs. High interest rate debt needs to be paid off, lower interest rate can be held longer. If you are holding a big amount of debt that is high in interest then you want to tackle this immediately. If you have a lump sum of cash to pay off the loan, then do so, as interest is always accruing. You can temporarily put a hold on retirement investing and aggressively pay off the loan with the highest interest rate.

Paying back debt is a numbers game as much as it is a philosophical game. Figure out the balance that works for you.

Is 2019 A Good Time To Buy A House In The Bay Area?

The Bay Area along with San Francisco has well over 40,000 companies and over 10,000 investors. The region is also home to over 80 Unicorns. In 2018 alone the Bay Area housed 18 Fortune 500 companies. Out of the FAANG grouping of stocks, Facebook, Apple, Netflix and Google are all based in the Bay Area. That’s right, 80% of the FAANG’s are located between San Mateo and Los Gatos. These companies have tens of thousands of employees making six figure salaries right here in the bay. Stock options and all. This precious sliver of land that reaches from SF to SJ is also home to Stanford and Cal blessed with the most perfect weather imaginable to a Homo Sapien.

Historically

Since around 1990 we have had 3 major busts: 1991, dot com bubble of 2000, and the September 2008 housing crisis. Even though predicting market movements is difficult we do know with certainty that markets crash from time to time. And even though markets do crash, they bounce back with vigor and then some. The SP500, Dow, NASDAQ and Bay Area housing markets all have a cyclical nature of growth and bust. It’s insane how prolonged the 2011 to 2018 bull market has been for Bay Area housing as seven years of appreciation seems like an eternity. It takes many months, and often over a year to have a subtle inflection point materialize into something that we can actually feel. March 2018 was an inflection point for the Bay Area as housing began to cool off. Bay prices stopped increasing at the rate they were increasing and housing has seen fewer multiple offers. Only in the Bay Area can we safely say that whatever goes down, must come up.

Below is one of my favorite charts about the housing boom and bust cycle. We can see that the Bay Area market has seen a few busts, but what’s amazing is that every single rebound has broken past previous highs. Look at the 2001 to 2008 growth. We saw prices increase 59% and then had a massive crash that reduced prices by 27%. One would think that this would be the end of growth for a very long time and that prices would stagnate for years. But in 2011 the Bay Area market did an 80% increase over the next 7 years. Where else in the world can we see a graph like this? Probably only a handful of cities. Most of the graphs resemble climbing Mount Everest. You have highs and dips, but the end destination is always the summit.

 

Mortgage Rates Are Generally On The Rise

I’ve noticed a lot of people rushing to buy houses because the interest rate is on the rise. That’s definitely a good reason to lock in a cheap rate. For example, if you are borrowing $500k, an increase from 4% to 5% interest rate will cause your mortgage to jump $300/month. That’s a decent difference, but not a life changing difference. Many of us guilty Siliconites spend that on lunch at work every month. Interest rates are creeping up but also note that housing prices are beginning to decline as well. You may come out further ahead if you buy a cheaper house with a slightly higher interest rate. Do a few calculations of buying now vs later at higher rates and see what you come up with.

This graph is from Jan 2016 to Feb 2019. You can see that the interest rates have started to go up since September 2016, but recently have been coming down since Nov 2018.

Bay Area Counties Performance

Santa Clara County and San Mateo County are the most desirable counties to purchase in. I would put San Mateo County ahead of Santa Clara County in terms of desirability which in turns makes it more expensive. Everyone wants to be on the Peninsula! The average median house in California is $538K, where as San Francisco County is more than thrice expensive. Remember median means half way, so 50% of the homes are cheaper, and 50% are more expensive than the figure below:

It’s 2019 Should I Buy?

If I have to make a call, I’m going to say that it’s not the best time to buy. Prices are not increasing at the same rate as they have been. Multiple offers have cooled down and the stock market has taken a dip but rebounded back to some extent.

I would say if you can fulfill all of the criteria below then it makes sense to make a purchase today. Still, I would really wait till the end of 2019 as I  don’t see prices increasing through the end of the year:

  • You plan to live in your house for the long haul, about 5 years or longer. This way if you buy at the dip, you can hold the house long enough to come out in the positive.
  • You can put at least 20% as a downpayment on your house/condo/townhouse. You don’t want to be stuck with PMI. Also, if you can’t put 20% down, you will need to borrow a huge sum which means a big mortgage and a lot of interest cost.
  • You have an emergency fund (remember this article?) that has at least 6 months worth of savings to pay all of your bills. You need to have this after putting your 20% down.
  • You can comfortably pay your mortgage, property tax, HOA, home repairs, and a million other necessary bills and still have some savings left every month.
  • You and your spouse have stable incomes that can pay for massive Bay Area mortgages

What Is An IRA?

A Quick Example

Let me first get your attention by using a simple example. If you are 30 years old with $0 in your retirement account, and you contribute $5,500 annually at a 7% return, how much money will you have when you hit retirement when you are 65? Using Bankrate’s Roth IRA calculator we can see below that your account would balloon to $813K.

Our principal contributions (the money you put in every month) itself is $192k, which helps us yield another $612k through growth.The monthly contribution comes down to about $458 every month. That’s not so bad.

The IRA

You probably have noticed but the talk about retirement planning is around us perennially. It’s nothing new as we are constantly reminded how underprepared we are on our retirement savings. Radio talk show hosts, webinars on YouTube, Finance experts on the news, the big brokerage firms and their advertising…all of them telling us the same thing: Open an IRA today and start contributing to it.

The IRA, pronounced eye-ruh, stands for Individual Retirement Account which is a special type of account that anyone can open for themselves. The ultimate purpose of this account is to help you live a cushier life after you have retired from your livelihood. You see, we spend on average 40 some years working from adolescence to retirement. We are focused on making money, spending money on ourselves and sometimes saving it if we are smart. But what about saving after you have retired from your livelihood? What about saving for when you need the money say 40 years from now? We will never save for retirement unless we have a structured way of approaching this problem.

So how does the IRA help us live a cushier life in our post-retirement world? Well, it’s an account that you create and fund on a monthly basis. If you reach into that account for a withdrawal you could get taxed and penalized (There’s some minutiae around this which we will touch ahead). An IRA will help you allocate (set aside) money early on. Basically every month, out of your paycheck, you will fund your IRA. You can choose to invest your paycheck in stocks, bonds, and other instruments and you can open one at any bank or online brokerage.

Let’s peel back a layer and get deeper into the details to see how this whole retirement planning thing works.

IRA’s generally come in two different flavors….

Traditional IRA vs Roth IRA

In a Traditional IRA you set aside a few bucks every month into your IRA account. One of the biggest benefits of doing this is that you can deduct this amount from your personal income, which means that your taxable income is reduced and you will ultimately pay less taxes.That’s definitely great. Your money will grow, year after year, and you don’t have to worry about paying capital gains on these when you do your yearly taxes. But….once you hit retirement age and withdraw the money is when you will be hit with taxes. So essentially you see your money grow tax free over the years, but you pay taxes at the end when you withdraw.

In a Roth IRA you also set aside a few bucks every month and deposit it into your Roth IRA. However, you can’t deduct these contributions from your taxable income like you did with the Traditional IRA. And so when you finally withdraw funds from your Roth you can do so without having to be pay tax. Why? Because your monthly contributions to your Roth IRA were taxed as you made the contributions.  Pay taxes now on your monthly contributions and withdraw tax free later without worry. This can be good because say, 40 years from now when you retire, the taxes may be super high. That way you can protect yourself against crazy high taxes in the future. Also it is generally easier to pay taxes when you have a job rather than paying taxes when you are retired. Another reason to go for the Roth.

The Devil Is In The Details

There are a myriad of detailed rules on the Traditional and Roth IRA accounts. They have to do with your age, the age of the account, and qualifying withdrawals you can make without penalty. We are going to keep it very high level so you can can focus on understanding the concept.

If you are under 50 you can contribute a maximum of $6,000 annually in your Roth or Traditional IRA. If you are over 70 you can contribute $7,000 annually. If you are married filing jointly you guys can’t make more than $203K, and if you are single the cutoff is $137K. If you are 59.5 yrs old and haven’t had your Roth opened for at least 5 years then you will owe taxes and a 10% penalty if you withdraw.

Regarding withdrawals from a Roth IRA: If you are at least 59.5 years old and have had the account for 5 years, you can withdraw unlimited without penalty or tax. You are allowed to take out $10k as a first time home buyer without penalty (taxes still apply).

Reasons To Open An IRA

The number one reason anyone opens an IRA is so that your money can grow. We all know that long term growth is really bolstered by big contributions at an earlier age. The goal is to have a nice pile of cash waiting to you by the time you hit retirement age.

Should You Open An IRA?

That’s the big question. We will reserve another separate article to answer just this question. But there’s no doubt that the Roth IRA seems to be a better deal than the Traditional IRA. You can grow your money in a separate account and not be tempted to touch it. Paying taxes in the beginning also seems to be beneficial. This is definitely a step towards creating a cushy post-retirement life.