When you work through the numbers, the savings that stem from early repayment of a loan can seem almost too good to be true. Can a few dollars a month really add up to, for example, $25,000 of savings?
When you save money over long periods of time and let the interest compound, the amount of interest you ultimately earn becomes very large. In effect, when you pay an extra $20 a month on a 9 percent mortgage, you're saving $20 each month in a savings account that pays 9 percent. By "saving" this $20 over more than 25 years, you earn a lot of interest. In the earlier example, this monthly $20 really would add up to roughly $23,000.
But you can't look just at the interest savings. If you placed the same $20 a month into a money market fund, purchased savings bonds, or invested in a stock market mutual fund, you would also accumulate interest or investment income.
How can you know whether early repayment of a loan makes sense? Simply compare the interest rate on the loan with the interest rate (or investment rate of return) you would earn on alternative investments. If you can place money in a money market fund that earns 6 percent or repay a mortgage charging you 9 percent, you'll do better by repaying the mortgage. Its interest rate exceeds the interest rate of the money market account. But if you can stick money in a small company stock fund and earn 12 percent or repay a mortgage charging you 9 percent, you'll do better by putting your money in the stock fund.
One complicating factor, however, relates to income taxes. Some interest expense, such as mortgage interest, is tax-deductible. What's more, some interest income is tax-exempt, and some interest income isn't tax-deferred. Income taxes make early repayment decisions a little bit complicated, but here are four rules of thumb:
If you're a business owner with the ability to invest additional funds in the business—and that investment will produce extra profits—you should usually make this investment first. Investments in small businesses often return 20 percent to 30 percent annually. If you can get that sort of return, every other opportunity pales in comparison. Note that in Chapter 14, I describe how to estimate the returns you receive from business investments.
Usually, if you have extra money that you can tie up for a long time and can't invest additional money profitably in your business, you'll make the most money by saving your money in a way that provides you with an initial tax deduction and where the interest compounds tax free, such as a 401(k) plan or an IRA. (Opportunities in which an employer kicks in an extra amount by matching a portion of your contribution are usually too good to pass up—if you can afford them.)
If you've taken advantage of investment options that give you tax breaks and you want to save additional money, your next best bet is usually to pay off any loans or credit cards that charge interest you can't deduct, such as credit card debt. Start with the loan or credit card charging the highest interest rate and then work your way down to the loan or credit card charging the lowest interest rate. For this to really work, of course, you can't go out and charge a credit card back up to its limit after you repay it.
If you repay loans with nondeductible interest and you still have additional money you want to save, you can begin repaying loans that charge tax-deductible interest. Again, you should start with the loan charging the highest interest rate first.
Understanding the Mechanics
Successful saving relies on a simple financial truth: You should save money in a way that results in the highest annual interest, including all the income tax effects.
It's tricky to include income taxes in the calculations, however. They affect your savings in two ways. One way is that they may reduce the interest income you receive or the interest expense you save. If interest income is taxed, for example, you need to multiply the pretax interest rate by the factor (1-marginal tax rate) to calculate the after-income-taxes interest rate. And if interest expense is tax-deductible, you need to multiply the interest rate by the factor (1-marginal tax rate) to calculate the after-income-taxes interest rate.
NOTE
The marginal tax rate is the tax rate you pay on your last dollars of income.
For example, suppose you have four savings options: a credit card charging 12 percent nondeductible interest, a mortgage charging 6 percent tax-deductible interest, a tax-exempt money market fund earning 4 percent; and a mutual fund earning 9 percent taxable interest income. To know which of these savings opportunities is best, you need to calculate the after-income-taxes interest rates. If your marginal income tax rate equals 33 percent—meaning you pay $.33 in income taxes on your last dollars of income—the after-income-taxes interest rates are as follows:
12 percent interest on the credit card
6 percent interest on the mutual fund
4 percent interest on the mortgage
4 percent interest on the tax-exempt money market fund
In this case, your best savings opportunity is the credit card; by repaying it you save 12 percent. Next best is the mutual fund because even after paying the income taxes, you'll earn 6 percent. Finally, the mortgage and tax-exempt money market fund savings opportunities produce 4 percent after you deduct the effect of income taxes.
TIP
The difference between percentages such as 12 percent and 6 percent may not seem all that large. But choosing the savings opportunity with the highest after-income-taxes rate delivers big benefits. If you invest $20 each month in something paying 6 percent after income taxes, you'll accumulate $5,107 over 25 years. But if you invest $20 each month in something paying 12 percent after income taxes, you'll accumulate $13,848 over 25 years.
The second complicating factor stems from the tax deduction you sometimes get for certain kinds of investments, such as IRAs and 401(k) plans. When you get an immediate tax deduction, you actually get to boost your savings amount by the tax deduction. This effectively boosts the interest rate.
For example, if you have an extra $1,000 to save and use it to repay a credit card charging 12 percent, you will save $120 of interest expense (12% * $1,000).
If you save the $1,000 in a way that results in a tax deduction, such as through an IRA, things can change quite a bit. Say your marginal income tax rate is 33 percent. In this case, you can actually contribute $1,500. ($1,000 / the factor [1-marginal tax rate]). The arithmetic might not make sense, but the result should. If you have $1,000 to save but you get a 33 percent tax deduction, you can actually save $1,500, because you'll get a $500 tax deduction ($1,500 *33%).
What's more, by investing in a tax-deferred opportunity, you avoid paying income taxes while you're earning interest. (A tax-deferred investment just lets you postpone paying the income taxes.) If you invest in a stock mutual fund earning 10 percent, for example, you can keep the whole 10 percent as long as you leave the money in the stock mutual fund. If you work out the interest income calculations, you would find that you earn 10 percent on $1,500, or $150. So the tax deduction and the tax-deferred interest income mean you'll earn more annually on the stock mutual fund paying 10 percent than you will save on the credit card charging 12 percent.
Be aware that ultimately you pay income taxes on the money you take out of a tax-deferred investment opportunity, such as an IRA. In the example, you would need to pay back the $500 income tax deduction, and you would also need to pay income taxes on the $150. (At 33 percent, you would pay $50 of taxes on the $150 of interest income, too.)
In general, however, if you're saving for retirement, it usually still makes sense to go with a savings opportunity that produces a tax deduction and lets you postpone your income taxes. The reason is that the income taxes you postpone also boost your savings—and thereby boost your interest rate. (It's also possible that your marginal income tax rate will be lower when you withdraw money from a tax-deferred savings opportunity.)
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