Carrying debt while investing is known as “leverage.” Leverage can increase your net worth if you’re investing borrowed money at a higher return than the interest rate you pay to borrow the funds. However, high return assets such as stocks come with high volatility. Rather than using bonds to decrease your risk exposure, consider paying down debt.
When to Pay Down Debt
Leverage is good when you are far from (before or after) your target retirement date but as you approach your target retirement date you need to take less and less risk to mitigate target retirement date risk and sequence of returns risk. In our last post, we covered mitigating these risks using bonds. If you have debt, does it still make sense to use bonds to mitigate these risks?
From a net worth perspective, investing in bonds that have a lower expected return than the interest you pay on your debt is a bad idea. If you have debt costing you 3% or more, you should consider paying down your debt rather than investing in bonds.
You can sell your bonds to pay down some debt, but be careful to incorporate capital gains into the decision if those bonds are in a taxable account. Alternatively, you could split your monthly investment contributions and allocate a percentage equal to your target stock allocation to invest purely in stocks and a percentage equal to your target bond allocation to pay off debt.
Paying down debt actually decreases your risk exposure more than investing in bonds does. While paying down debt decreases the percentage of your net worth exposed to the stock market by keeping assets out of the stock market the same way investing in bonds does, paying down debt provides a guaranteed return equal to the interest rate.
When to Invest In Bonds
There are two scenarios where it makes sense to leverage debt for bonds:
- When the expected return on bonds is higher than the interest rate on your debt
- This is the case for some low-interest mortgage holders who after tax deductions pay less than 3 percent interest on their loans
- When liquidity takes precedence over maximizing net worth such as when:
- Growing an emergency fund
- Saving for short-term goals such as making a down payment on a house, or paying for a wedding.
- Saving for long-term goals such as launching a business or taking a sabbatical.
- This is actually why I currently hold on to my mortgage in favor of contributing to bonds.