In hedge fund speak, a “carry trade” is when you borrow money at low rates and invest in something with higher rates. The most well-known example involved the Japanese Yen – borrowing at less than 1 percent and buying U.S. or European debt paying closer to 5 percent. Easy money. Yen appreciation was the largest risk.
As part of my job, I get to see how a lot of individuals manage their financial lives. One of the most common mistakes is inadvertently creating a negative carry. It happens when folks hold a high level of cash or extremely low paying bonds, while simultaneously carrying large debt balances. A second grader can quickly see why borrowing at 4.5 percent and lending at 0.5 percent doesn’t make much sense. But in my experience, the majority of Americans with over half of a million dollars in liquid assets are doing exactly that. Usually the debt is a mortgage, but it is not unusual to see folks maintaining significant cash and credit card debt simultaneously.
Cash vs. credit card debt
It’s been said a million times, but once more can’t hurt: if you have high-interest credit card debt (anything above 8 percent), and you can afford to pay it off, do it. Today.
Mortgages are a little trickier. For the remainder of this article, we will discuss whether or not to prepay a mortgage, assuming the individual can pre-pay at no cost. The first question is why one is holding high cash to begin with. If it is for a known future expense, then it must remain in cash and the negative carry is simply the cost required for liquidity. Other common reasons I hear for holding large cash balances include “for when the market looks good again,” or “for peace of mind.”
Those waiting for the market to look good again are usually actually waiting until the next market peak. These people are almost always better off paying down mortgage debt instead. Peace of mind is a valid thing to pay for, but it must be reasonable. A large cash balance can be nice, but if an individual has good access to credit, it is not usually necessary.
Cash vs. mortgage
There are other variables. The magnitude of the interest rate spread is a big one. If your mortgage rate is 3.5 percent, it is entirely different than if it is 5 percent. Future interest rate expectations should also be considered. You may only be getting 1 percent on your cash now, but if you expect to get 6 percent in a few years it may be logical to eat the current cost of keeping your mortgage. Also, don’t forget the tax deductibility of your mortgage interest.
My rule of thumb is, unless you are likely to need the cash, try to avoid (or at least minimize) maintaining after-tax negative carry over 2 percent. Yes, interest rates could rise, but then again they might not. In the meantime, the spread is costing you real money every day. Does that mean all of your cash and low yielding bonds should be used to pay down your mortgage? Possibly, but every situation is different. It’s worth thinking it through to get it right. A few hundred dollars or a few thousand dollars a year in extra interest cost may not sound like much, but with compounding it can end up having a significant impact on your retirement.
Image used under Creative Commons by Flickr user 401K.
Craig Birk, CFP®
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