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  • Writer's pictureThomas Hayes

Should I pay off my loan, or invest the money?

I recently saw a post that posed an interesting question, “Should I buy a covered call ETF with a 10%+ dividend yield to offset my 7% HELOC (home equity line of credit)?”. In this case the person intended to offset the 7% interest on their loan, by collecting a 10% dividend yield on the ETF, with the other 3% in interest kept as potential profit. It may sound like a great plan, but there are a few different issues with this approach. The first issue is that dividends are never guaranteed, and the dividend yield on a covered call ETF generally isn’t a fixed rate, so it could potentially fall below that 7% HELOC interest rate. The other issue is the impact of taxes. You may be able to collect a 10% dividend yield before taxes, but depending on how those dividends are classified for tax purposes, you could end up with much less in the end. You also have to consider what happens in the event the ETF drops in price. So, is this approach ever viable, and if so, when?

What this really boils down to is the age-old question, “Should I invest my money, or pay down debt?”. The answer can be complicated, so let’s look at a few different scenarios. Let’s start with the example above. Let’s assume you have a home equity loan with a 7% interest rate, and the opportunity to buy a covered call ETF with a 10% annualized dividend yield. Let’s also assume that the majority of these dividends are taxed as ordinary income, as is typically the case with these types of ETFs, and that this investor falls exactly at the top end of 24% marginal tax bracket, putting their effective tax rate at 20.37%. After taxes, that 10% dividend yield would come out to just 7.96% in net return, hardly clearing the hurdle of 7% interest on the loan. This also assumes the ETF doesn’t experience any kind of sell-off, of which there is significant risk. Even in the perfect scenario, it is extremely unlikely the covered call ETF will achieve that 10%+ return on an annualized basis, given that the average annual return of the S&P 500 since 1957 is 10.15% before any fees.[1] Based on that long term average, even with a portfolio invested 100% in stocks, and a 15 or 20% tax rate on interest or capital gains, that 7% interest rate hurdle is going to be very difficult to clear without significant risk.

We run into another major issue with this strategy. Returns in a given year are often far from that 10.15% long-term average, and there can be significant drawdowns along the way. This is known as sequence of return risk. If the ETF you choose to buy experiences a large drawdown, it could have a significant impact on your principal, forcing you to wait a long period of time for the market to recover in order to pay down your loan. In the meantime, you’re stuck paying that 7% interest rate. If the drawdown lasts long enough, and you can’t access other capital to pay the interest, it’s possible you’ll be forced to sell so much of that investment during the drawdown, that you won’t be able to catch up and clear that hurdle again, especially after taxes. It may even cause your principal to be wiped out entirely in a scenario where there is an extreme drawdown.

Now let’s consider when it might make sense to use this strategy. Imagine you’re a homeowner with a 3.25% 30-year fixed rate mortgage, and you have the option to pay down the mortgage balance, or invest in a portfolio of stocks tracking the S&P 500. In this case, assuming the top end of that same 24% marginal tax bracket, and that you achieve the long-term average return of the S&P 500 at 10.15%, you’ll have an after-tax return of 8.08%. This gives you an annual return of 4.83% vs paying down your mortgage early. In this scenario it likely makes sense to invest the funds rather than pay down the loan balance. Even assuming you purchase, 1-year US Treasury bill yielding 5.1%, you can collect 4.06% in after tax interest. With the risk of permanent loss on a 1-year US Treasury bill extremely low, and your interest rate locked in if you hold the bond until its due date, you have a defined rate of return that outpaces the interest on your loan. With a loan rate of just 3.25%, it could be worth considering investing the funds rather than to paying down the mortgage balance.

If you’re considering whether to pay off debt or invest, it’s important to take these factors into consideration. The lower the interest rate, the more likely it is that you’ll want to pay the loan as scheduled, and invest any excess capital. It’s always a good idea to get a financial advisor or planner involved in the conversation to show you your options, and help you determine the interest rate threshold at which you should consider paying down a loan vs investing the money instead.

​The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

PLEASE NOTE: The information being provided is strictly as a courtesy. When you link to any of the web sites included, we make no representation as to the completeness or accuracy of information provided at these web sites. The opinions found therein are those of the author(s) of the article or website.


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