Debt Payoff as Risk-free Asset Allocation

Over the years this blog has been in existence I have noted that I use debt strategically.  What I haven’t talked about so far is my process for paying off debt.  Today we’re going to talk about how I treat our debt payoff as part of our asset allocation.

The Eternal Struggle: Debt Payoff or Investing

There is an eternal struggle between paying off ones debt early or investing.  Leverage from debt can be used to otherwise increase your returns beyond normal levels.  By paying off debt early you are forgoing this leverage and incurring the opportunity cost of not investing.      But by paying off debt you may increase your psychological well-being, so by investing you are incurring the cost of the stress your debt may cause you.

Get Control of Your Debt First

So many people talk about paying off debt in the context of digging themselves out of a mess.  If you don’t control your finances you probably shouldn’t focus on investing.  In that case paying off debt at a higher rate is important to get things under control.    But for those who manage their debt and it’s payment strategically  there is potentially another option, manage your debt payments as part of your asset allocation.

Fixed Debt Can Be More Easily Compared to Investments

Debt comes in 2 flavors, fixed interest and variable rate debt.  For the purposes of this process I assume you are working with mostly fixed debt.  Your picture may change with a debt where the interest rate changes over time, variable debt.   A potential change in interest rate should influence your payoff strategy.  Fixed debt makes an easier comparison so that will be my focus.

Risk-Free Investments and Debt Payoff have the Same Return Risk

When you think of paying the future interest on your debts you are essentially talking about a guaranteed expense.  Unless you can sell the underlying asset or declare bankruptcy you will be paying that expense.  Conversely when you own a bond from the government it is considered a risk-free guaranteed investment, also known as the risk-less rate of return.  Essentially both have the same risk of changing over time, near 0.  Thus from a risk or variance perspective they are roughly equal.

Liability Matching

When you talk about expenses and payments one great way to manage them is called liability matching.  The concept is that you want to match your expense timing to your return timing so they offset.  The impact if at the same rate of return for the same time period is they cancel each other out.  The two concepts combined means that your debt payment, unless you plan on selling the asset, is functionally equivalent if both interest rates sit at the current risk-free rate for the same time period.

Comparing Risk-free Rates

Now of course there is still a difference since your debt interest rate is probably different then the risk-free rate.  But very likely the rate of interest on your debt is higher than the current bond rate.  This is especially true when you consider you pay taxes on investment return and depending on if you itemize you deduct taxes on some debts like a mortgage.  So we can establish that in most cases paying debt is of higher return for the same risk as investing in a risk free asset like a treasury bond.

Liquidity Differences

The final thing to consider before we close out our proof of equivalence is liquidity.  Obviously a debt payment is not a liquid investment like some bonds which can be sold on the secondary market (though perhaps at a loss).  That being said odds are your entire risk-free asset allocation does not need to be liquid.  The ideas in this post speak to values beyond what you would require for an emergency fund, IE your liquid funds.    In some cases you may not even need liquid funds depending on your risk tolerance and emergency fund form.  In any case that is beyond the scope of this post.

Paying Off Debt in Proportion to Risk-Less Asset Allocation

So based on everything we’ve discussed so far it’s obvious in most cases we are better off paying off debt then investing in risk-free assets.  This gives us an easy framework for the decision to pay off our debt.  Put simply we should pay off debt in proportion to our risk-free asset allocation.     

Determining the portion to pay towards the debt is a bit trickier then buying bonds.  For a single year timeframe it is easy, calculate how much you need to invest in bonds to maintain your asset allocation.  Then put that money into debt.  

Managing Rebalancing with Mortgage Debt Payoff

Managed across multiple years things are a bit more tricky.   You still need to pay your debt in proportion to your other investments to maintain your asset allocation in lieu of bonds.  However, If you recall I like to rebalance funds across accounts to my chosen allocation via new money.   In the case of using your debt as your risk free investment previous years debt payments do not appear in your assets to determine your rebalancing needs.  As such when you calculate your risk-free rebalancing needs from year to year you need a good method to understand the change due to return from year to year.  The ease or difficulty here depends on the debt.

Home Equity for Rebalance Calculations

If you have something backed by a defined asset like a mortgage then a simple way would be to add your home equity to your current amount in bonds.  Then compare that number to your other assets to determine an asset allocation.  While I do not consider my home an investment, for the purposes of my asset allocation I do utilize it in rebalancing calculations.

Original Loan Amount for Rebalance Calculations

If you have something not backed by a hard sellable asset like a student loan then you might utilize the original value of loan minus the amount remaining as a plug-in similar to your equity.    The plug-in added to your bonds gives you your risk-free assets.  The current proportion gives you an amount for any future rebalance or contribution amount.

This Strategy Applies Best to Larger Debts

Now I will admit this all is a bit of effort.  For really small debts, or strategic debt usage like our former car purchase at 0 percent, this method may not be worth the effort.  But for larger debts it covers all the basis.  

Debt Payoff as a Risk Free Investment is the Right Answer

The argued point for paying your debt off early is for the psychological impact.  Your risk free investments are also about the psychological impact.  Both are about allowing you to sleep better at night when the market drops your risky stock assets.      The argument for not paying debt off early is the loss in return otherwise obtained by risky assets.  But the question of debt or risky asset is the wrong question.    You must compare items with similar risk, and thus debt payment as a risk free investment is the right answer.

How do you determine debt payoff amounts?  Do you pay ahead?