I hope your weekend was wonderful.
I was looking over my recent posts and realized that I haven’t written about investing in a while. It sometimes comes up in connection with other things, but I haven’t really focused on it in for a bit.
So as not to neglect one of my favorite subjects, I want to talk some about investing this week.
The topic has been on my mind a little lately because of the refinance I mentioned last week. I was comparing my and Ben’s current interest rate with the new one in order to figure out if refinancing was a good deal for us.
You probably find yourself doing a similar comparison in many contexts. Should I payoff my student loans or invest in my 401k? Should I add extra money to my mortgage payments? What investment should I buy?
The real question is “how do I choose?” This is one of the most fundamental questions in investing, and here are three steps you to consider when making your decision.
1. Compare the annual rate of returns and/or the interest rates – The first step involves a simple comparison of the return on your investment (ROI). In other words, would using your money for one purpose (e.g., paying extra on your mortgage at 8%), make you more money in the long run than using it for another (e.g., investing in an index fund that has historically produced an 7% return). In this example, everything being equal, you would get a better return on your money by paying extra on the mortgage. But you need to consider a couple more things.
2. Make adjustments for taxes and fees – The next step would be to examine the effect of taxes on your rate of return (also known as after-tax yield). The formula is:
after tax yield = pre-tax yield – (1-marginal tax rate)
For example, mortgage interest is tax-deductible if you itemize on your return. Therefore an 8% mortgage, really on costs you 5.6% if you’re in the 30% combined federal and state marginal tax brackets (.08 *.70). It’s also the same with your investment returns, if you have them in a taxable or tax-deferred account. A return of 7% only nets you 4.9% after taxes. However, if that money was held in a Roth account, the entire 7% return would be yours. As you can see, the tax consequences make a significant difference in choosing one investment over another. You run into the same scenario with fees on investment accounts. The fees your brokerage or your investment advisor charges eat into your return.
3. Take into consideration risk – Lastly, when weighing the benefit of each investment option you have to take into account risk. Paying off a debt – credit card, mortgage, car loan, etc. – is a guaranteed return. The money you pay towards the debt reduces what you have to pay in the future immediately. Stocks, bonds, and mutual funds come subject to their own risks. While the average return may be 7%, there’s no guarantee that you will achieve that return. By investing that money in the market you are betting that you will get an average return. To me, if the ROIs are close, I would much rather have the guaranteed return. In other words, risk adds an extra cost.
Choosing between two investment options is not as straight-forward as you might think. But using these three criteria can steer you in the direction of making the best financial choice.