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Portfolio Perspectives

Explore the intersection between timely topics and potential effects to your investments in Portfolio Perspectives reports.

To Invest or Reduce Debt?

Investment Implementation

David Furst, CFA®, Advice Strategy
Taylor McLeod, Analyst

Many young investors may be grappling with high levels of personal debt. Specifically, student debt, which has ballooned to roughly $1.73 trillion in the second quarter of 2021, according to the Federal Reserve. The graph below depicts the large difference in consumer credit between student loans, revolving debt and motor vehicle loans. This makes student loans the second largest category of consumer borrowing (behind mortgages) in the United States. As the newest generation of investors begin their careers and start to earn money, they will face an onerous choice; invest early or focus on paying off their debt?

Unfortunately “it depends.” This report will explore the framework that younger investors can use to help guide their decision, but because of the wide range of variables, investors should consider their own individual needs.

Consumer Credit GrowthThis chart illustrates the difference in consumer credit growth between revolving debt, motor vehicle loans and student loans over a time span of five different quarters. For more information, please contact your Financial Advisor or the Investment Resource Center at 1-866-975-0166.Source: Federal Reserve/Wells Fargo Advisors as of 08/20/21. Student Loans originated under the Federal Family Education Loan Program and the Direct Loan Program; Perkins loans; and private student loans without government guarantees. Data for this memo item are released for each quarter-end month. For full data definition, see disclosure section.

Steps to take:

First, consider establishing an emergency fund: The fund doesn’t have to be large, but it should be enough to cover an unexpected expense such as an insurance deductible, an emergency room co-pay or a car repair. Set the funds aside and avoid spending it unless absolutely necessary.

Second, strive to make payments on time: Late payment fees and penalty interest rates can be counterproductive. Consider auto pay features (when available) to help borrowers stay organized. If a payment is going to be late, consider notifying the lender in advance. Some lenders may be willing to work with a borrower if they have been notified in advance.

A bit of math…

Once an emergency reserve is accumulated, and all minimum required loan payments can be made, investors can begin to assess whether it may be beneficial to invest their incremental income or use the funds to pay on their debt.

To illustrate this, below is a chart showing the natural progression of a hypothetical 10-year loan for $50,000 starting January 2020, with an interest rate of 7.5%. This would make the payments roughly $600 per month. If only the minimum payments were made, the loan would be fully paid off by 2030, and the borrower would have paid over $21,000 in interest. However, if the borrower were able to pay just an additional $100 per month, they would save about $4,500 of interest over the life of the loan, and have it fully paid off two years early. Tempting...

Hypothetical Student Loan AmortizationThis chart depicts a hypothetical example showing the natural progression of a 10-year loan for $50,000 starting January 2020, with an interest rate of 7.5%. This would make the payments $600 per month. If only the minimum payments were made, the loan would be fully paid off by 2030, and the borrower would have paid over $21,000 in interest. However, if the borrower were able to pay just an additional $100 per month, they would save about $4,500 of interest over the life of the loan, and have it fully paid off two years early. For more information, please contact your Financial Advisor or the Investment Resource Center at 1-866-975-0166.Source: Wells Fargo Advisors. Chart is for educational/illustrative purposes only and is not intended to represent an actual loan.

In this hypothetical illustration, making more than the minimum required monthly payments, the borrower is giving the lender back their money earlier than originally promised. These additional payments served to reduce the remaining principal on the loan and as a result, reduced the total amount of interest the hypothetical borrower paid.

A Bird in the Hand?

When additional loan payments are made, the borrower can typically calculate how much they will save in interest cost as shown above. However, if those additional funds are invested instead, it is more difficult to know with certainty, how much the investments will return. This is the fundamental tradeoff into which this report will dive into. For the purpose of this report we assume the borrower is able to make the minimum loan payments required, as well as have some cash remaining on the sidelines for potential investment.

To illustrate this decision, the chart below depicts a simulation of hypothetical market returns that could potentially occur over the 10-year period of the student loan. The interest cost on the loan is known at 7.5% (shown by the black horizontal dashed line), however investments fluctuate over time. If the market gains more than the interest cost, the borrower is better off investing rather than paying down their debt faster. However, if the market declines (or gains less than 7.5%) the borrower is better off using the funds to pay down their loan. Each dot on the chart represents a hypothetical annual investment return that could occur. The red dots indicate hypothetical returns greater than the interest cost of the loan, while purple dots indicate hypothetical investment returns below the interest cost. Thus red dots represent potential instances where the borrower is better off by investing additional funds, while the purple dots represent instances where the borrower is better off using those funds to pay down their loan.

Certain vs. Uncertain RatesThis chart depicts a simulation of hypothetical market returns that could potentially occur over a 10-year period of a student loan. The interest cost on the loan is known at 7.5% (shown by the black horizontal dashed line), with investments fluctuating over time. Each dot on the chart represents a hypothetical annual investment return that could occur. The pink dots indicate hypothetical returns greater than the interest cost of the loan, while purple dots indicate hypothetical investment returns below the interest cost. The pink dots represent potential instances where the borrower is better off by investing additional funds, while the purple dots represent instances where the borrower is better off using those funds to pay down their loan. For more information, please contact your Financial Advisor or the Investment Resource Center at 1-866-975-0166.Source: Wells Fargo Advisors. Chart is for educational/illustrative purposes only and is not intended to represent any market prediction, security, or portfolio. Simulation assumed a normal distribution of annual market returns with mean 6.0% and standard deviation 12.0%. Simulation results are heavily dependent on the mean and standard deviation assumptions of the distribution. Past performance does not guarantee future results.

The glaring issue remains that investors do not know beforehand what return their investments will generate. Economists often make predictions of what may lie ahead for markets, but these still are predictions, not guarantees. When paying off debt, the interest savings is certain. When investing, the return is not.

There are other factors to consider in addition to raw numbers. Investors and borrowers are people, and people are (to varying degrees) risk averse. Having debt can be stressful and emotional for many. Some people may prioritize debt reduction above all else, while others may not.

This is a potential key benefit of working with a financial advisor: Because both market conditions and peoples' lives can change at lightning pace, a financial advisor can help navigate these complex and sometimes emotional decisions.

An Unsatisfying Answer

Looking again to the simulation of market outcomes, if the borrower uses the additional $100 per month and reduces their loan balance, they would save roughly $4,500 in interest cost and pay off their loan two years early. If they instead invested the $100 each month, their investment results would fluctuate with the market conditions. Below is a depiction of 100 market condition simulations that could manifest over the 10-year life of the loan in the previous example.

Investing vs. Accelerated Debt Payoff SimulationThis chart depicts a hypothetical example of 100 market condition simulations that could manifest over the 10-year life of the loan in the previous example. For more information, please contact your Financial Advisor or the Investment Resource Center at 1-866-975-0166.Source: Wells Fargo Advisors Chart is for educational/illustrative purposes only and is not intended to represent any market prediction, security, or portfolio. Simulation assumed a normal distribution of annual market returns with mean 6.0% and standard deviation 12.0%. Simulation results are heavily dependent on the mean and standard deviation assumptions of the distribution. Past performance does not guarantee future results.

When the simulation assumes a normal distribution of 6.0% average annual return and a volatility of 12.0% (measured by standard deviation), investing the additional $100 per month returns more for the investor than the interest cost savings of early debt pay down roughly 40% of the time. However, these results are highly sensitive to the analyst's forecast of market returns and volatility. This example should not be considered advice on any specific situation for a borrower. The situation is merely presented to illustrate the type of analysis one may conduct to make a more informed decision about the tradeoff between investing and early debt pay down.

This process is going to vary from person to person. Ultimately, the decision will likely be based primarily on personal preferences and the borrower's overall financial situation.

So you’ve decided to pay off your debt. But how?

Increasing consumer debt levels brings more discussion about the potential problems it presents but possible solutions as well. The two most common approaches borrowers take to methodically reduce their debt burden are the Avalanche Method and the Snowball Method.

Avalanche Method

The Avalanche Method prioritizes a borrower's loans in order of interest rate, highest to lowest. The premise being, that by attacking loans with highest interest rates first, the borrower saves on interest cost. However, the borrower still must ensure they make the minimum required payments on all of their outstanding loans. Then any additional funds are directed toward supplementary payments to the loan with the highest interest rate. Once that loan is eliminated, the extra payments are directed to the loan with the second highest rate, and so on. This method minimizes the overall amount of interest the borrower ultimately pays over the life of their outstanding loans.

Snowball Method

Like the Avalanche Method, the Snowball Method assumes the borrower makes the minimum payments on all of their outstanding loans. The difference comes in which loans to then prioritize for additional payments. Borrowers direct extra money toward the loans with the lowest outstanding balance remaining (rather than the loan with the highest interest rate). Once the lowest balance loan is fully repaid, the borrower then directs additional payments to the next-smallest balance debt, and so on. The Snowball Method rewards a borrower with a success early in the process (paying off the smallest loan) to maintain motivation and make debt reduction less intimidating. However, because the smallest balance loan may not have the highest interest rate, the borrower may not save as much interest cost over the life of the loans as compared to the Avalanche Method.

Whichever method the borrower chooses, making additional payments to loans (above the minimum required payments) will ultimately reduce the amount of interest paid and shorten the amount of time the debt is outstanding. The key to early debt payoff is planning and budgeting. Having a monthly budget and sticking to it will give borrowers more confidence in their finances. Furthermore, incorporating a realistic budget into an overall investment plan, such as an Envision® plan, can ultimately help borrowers achieve their long-term financial goals. Talk to a financial advisor about how budgeting and Envision® planning can give you more confidence in your finances.

RESEARCH, CHARTS, AND ILLUSTRATIONS PROVIDED BY JUANA DIEZ DE ONATE – INVESTMENT IMPLEMENTATION ANALYST

Risk Disclosure

Data Definitions:

Consumer Credit Chart

Student Loans: Includes student loans originated under the Federal Family Education Loan Program and the Direct Loan Program; Perkins loans; and private student loans without government guarantees. This memo item includes loan balances that are not included in the non-revolving credit balances. Data for this memo item are released for each quarter-end month.

Motor Vehicle Loans: Includes motor vehicle loans owned and securitized by depository institutions, finance companies, credit unions, and non-financial business. Includes loans for passenger cars and other vehicles such as minivans, vans, sport-utility vehicles, pickup trucks, and similar light trucks for personal use. Loans for boats, motorcycles and recreational vehicles are not included. Data for this memo item are released for each quarter-end month.

Revolving Debt: Covers most credit extended to individuals, excluding loans secured by real estate.

'Certain vs. Uncertain Rates' Chart Disclosures:
The hypothetical portfolio returns (dots) displayed in the chart are the result of random sampling and generally accepted statistical practices. They do not represent the actual returns of any particular portfolio, index, security, or financial instrument over any specific period in history. The chart displays the results of 100 simulations of portfolio returns that an investor may experience over a 10-year period matching the maturity of the investor's outstanding loan. For each of the 100 simulation iterations (shown along the horizontal x-axis), 10 hypothetical annual returns were randomly sampled and stack-ranked from highest to lowest (shown along the vertical y-axis). The annual returns drawn for each simulation were sampled from a normal distribution with a mean of 6.0% and a standard deviation of 12.0%. If the simulation were re-run, results will differ.

'Investing vs. Accelerated Debt Payoff Simulation ' Chart Disclosures:
The chart displays the results of 100 simulations of the growth in an investor's hypothetical portfolio over a 10-year period matching the maturity of their outstanding loan. The investor is assumed to start with a portfolio of $0.00 and contribute $100.00 per month for each month in the 10-year period. The returns experienced in the investor's hypothetical portfolio are randomly sampled from a normal distribution of returns with a mean of 6.0% and a standard deviation of 12.0% following generally accepted statistical practices. The hypothetical returns sampled do not represent the actual returns of any particular portfolio, index, security or financial instrument over any specific period of time in history. If the simulation was re-run, results will differ.

All investing involves risk including loss of principal.

This information is for educational purposes only. It is not intended to represent any specific return, yield or investment and does not constitute a recommendation to invest in any particular fund or strategy. It is not a promise of future performance, an estimate of actual returns or of the volatility any client portfolio may experience. Past performance is no guarantee of future results.

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