How to Develop a Plan for Paying Down Debt

This is an updated version of an article that originally published on August 3, 2019. Investors spend a lot of time thinking about how much to allocate to various investment assets--stocks, bonds, and cash, mainly, as well as peripheral assets like gold. That's an essential decision, of course, as those asset-class choices will be among the primary determinants of how our investment portfolios behave.

What gets less attention, however, is what I've called primordial asset allocation--how we apportion our hard-earned resources across other assets and opportunities. One of the major allocation decisions that many of us make without a lot of thought is whether we steer our financial capital to debt paydown or investing in the market.

To cite a common example, we might reflexively put mortgage debt in the category of "good debt" and not prioritize prepayment, even though paying that debt down ahead of our lenders’ schedule would entail a much better guaranteed return on our dollars than steering more money to low-returning cash and bond investments. The more conservative our investment portfolios, the greater the benefit of debt prepayment in lieu of additional safe investments.

To help put a little bit of math around this exercise, you have to calculate a return on investment for both debt paydown as well as your investment accounts; that can help you prioritize future capital deployments. As you take stock of your total opportunity set, here are the key steps to take.

Step 1: Calculate your returns on investment for debt paydown. Using the Expected Return Worksheet, write down any debts you have outstanding, including mortgages, home equity loans or lines of credit (if you currently have a balance), student loans, or credit cards.

As you do so, take note of the following additional factors.

Interest Rate: This factor is straightforward if you have a fixed-rate loan. But if you have an (increasingly rare) adjustable-rate loan, calculating your borrowing costs is more complicated. Adjustable-rate mortgages typically fluctuate in line with prevailing market interest rates, which makes it tricky to forecast long-term borrowing costs. While interest rates are currently quite low relative to historic norms, which in turn benefits borrowers with variable-rate loans, that may not always be the case.

Tax Deductibility of Interest: Credit card debt has been rightly demonized as having no redeeming qualities whatsoever. But other types of debt may receive tax breaks that can help reduce your overall borrowing costs. For example, you're able to deduct mortgage-related interest on up to $750,000 of qualified loans, including mortgages, home equity loans, and home equity lines of credit. This deduction can be a particularly big advantage early in the life of your mortgage, when most of your payments go toward interest expenses. You may also be able to deduct student loan interest payments, up to a certain amount, provided your income falls below a certain threshold and you meet other requirements. However, it's worth noting that you have a choice of either itemizing deductions or claiming a standard deduction on your income tax form. If your itemized deductions aren't substantially higher than your standard deduction, the tax savings from your interest payments may not amount to much. The new tax laws enacted in late 2017 included a dramatic increase in the standard deduction amount, meaning that many fewer taxpayers will itemize their deductions than was the case in the past.

Private Mortgage Insurance. Private mortgage insurance is another factor to consider when deciding whether to invest in the market or to pay down your mortgage. Lenders typically require you to pay for this insurance if you have less than 20% equity in your home. Thus, if you're on the hook for PMI, you have a strong incentive to get rid of it as soon as you possibly can, either by paying down your principal value aggressively (and thereby building up your equity in the home) or by having your home reappraised if you've made substantial improvements to it.

Number of Years Until Retirement. This isn't as readily quantified as the above factors, but debt paydown often grows more attractive as retirement approaches. For retirees, having a paid-off home reduces the income they'll need to take from their portfolios once they retire. That, in turn, improves the odds that their portfolios will last throughout their lives. So if you're getting close to retirement, reducing or eliminating debt should top your list of priorities.

Step 2: Take stock of your investment accounts. Write down your current investment accounts on the worksheet. Indicate whether you're receiving any tax benefits by investing in that type of account, as well as whether you're earning any matching contributions. Leave the "Expected Return %" column blank.

Step 3 : Use Morningstar's Instant X-Ray tool to identify the stock/bond/cash mix for each of your investment accounts: 401(k)s, IRAs, and any taxable accounts. Start by entering each of your holdings into the tool, then click "Show Instant X-Ray" to see the stock/bond/cash mix (also called an asset allocation) for that account.

Step 4 : After you've found a stock/bond/cash breakdown for each of your accounts, calculate an expected return for each one. Of course, you can't be certain about the expected returns of any asset class, but a reasonable starting point is 1% for cash, 2% to 3% for bonds, and 6% for stock holdings, assuming you have a longish time horizon of at least 10 years.

If your account consists of some combination of stocks, bonds, and cash, you'll need to come up with a combined expected return. For example, if Instant X-Ray says your account consists of 10% cash, 50% bonds, and 40% stock, you'd calculate the expected return as follows: a 2.4% return from the stock portion of your portfolio (6% times 0.40), a 1.5% return from the bond portion of your portfolio (3% times 0.50), and 0.1% contribution from the cash portion of your portfolio (1% times 0.10). The aggregate expected return for such a portfolio would be 4.0%. (2.4% + 1.5% + 0.1%)

Step 5 : Compare the potential rates of return for your investment assets with the interest that you're paying to service your debt. Prioritize your spending in the following sequence:

First priority (tie): Debt with high interest rate relative to what your investments are apt to earn, where interest is not deductible and/or you're paying private mortgage insurance. Credit card debt is an obvious example.

First priority (tie): Company retirement-plan contributions that your employer is matching.

Second priority: Debt with high interest rates relative to what your investments are apt to earn, where interest is tax-deductible--or, debt with reasonable interest rates (4% to 5%), where interest is not tax-deductible.

Third priority (tie): Investments with reasonable expected rates of return (4% to 5%) that also enjoy tax-favored status--IRAs and 401(k)s.

Third priority (tie): Debt with reasonable interest rates (4% to 5%) and tax-deductible interest.

Fourth priority: Investments whose expected rates of return are in line with interest on debt and that enjoy no tax benefits.

As you go through this exercise, you're almost certain to encounter one or two toss-ups. When you do, the tie should go to the investment that offers you the most certain return. For example, say your mortgage interest is 3% and you're forecasting a similar return on your IRA. Because the return on your mortgage paydown is certain, whereas your investment's return is not, it makes sense to prepay at least some of your mortgage each month before putting cash to work in the IRA.