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Here’s a realistic personal finance conundrum: You have stubborn debt that you can’t seem to get rid of, but, separately, funds are sitting and (ideally) growing in your investment accounts. What if you used that investment money to finally dramatically reduce your debt once and for all?
What may seem like a quick fix, however, has significant financial implications to be aware of (hello, capital gains tax). When possible, experts generally suggest avoiding using your investments to pay off debt. However, there is a caveat to this rule: when you have high interest debt.
Select, examines the pros and cons of selling your investments to pay off your debts.
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Selling investments to pay off high interest debt
If you have high-interest debt like unpaid credit card balances, it’s a good idea to take whatever steps you can to take care of that debt, advises Tony Molina, CPA and senior product specialist at the investment platform robo advisor wealth front.
“Looking at it from an interest rate perspective, if you’re paying 20% interest on credit card debt, you’ll need to make at least 20% on your investments to cover those interest charges,” he said. Molina told Select. “Nobody makes 20% year over year.”
Lynn DunstonCFP and partner of a wealth management company Moneta Group, agrees that you can quantify the best path to take when deciding whether to pay off debt or stay invested, but its threshold rate is much lower. Dunston provides an “industry common rule of thumb,” explaining that once the debt interest rate is above 4%, it’s harder for your investment gains to overcome the cost of interest.
“At this point, we generally recommend that you pay off your debt,” he says. “Of course, this is only a general rule and specific circumstances should always be taken into account when making important financial decisions.”
A good practice, Dunston adds, is to ask yourself what is the opportunity cost you are giving up by withdrawing money from your wallet to pay off debt. He wants you to think about what your investment money is for so you can weigh what might be compromised if you pay off the debt.
“The money invested will grow,” says Dunston. “If the debt in question has an interest rate of less than 4% and the money invested is earning 8%, you can walk away with the difference by staying invested. You can leave it to grow in an account and return later and use this money to pay reduce the debt.In this scenario, you will come out ahead by keeping the money invested.
Before Selling Your Investments, Consider These Alternatives
Now, while high-interest debt is the caveat here, it’s worth noting that using your investments as payment for that debt can be a final scenario. Sara Kalsman, CFP at robo-advisor Improvementrecommends first considering suspending contributions to your investments and prioritizing allocating those cash flows to paying off high-interest debt at a faster rate.
For example, you can use this money to speed up the payment of your credit card debt and combine it with a balance transfer credit card, where your payments can reduce your balance faster because they will not accumulate. additional interest for as long as the 0% APR introductory period lasts. The annual toll-free Citi Simplicity® Card offers an introductory APR of 0% for 21 months on balance transfers (afterwards, variable from 14.99% to 24.99%; balances must be transferred within four months of account opening).
0% for 21 months on balance transfers; 0% for 12 months on purchases
Balance Transfer Fee
5% of each balance transfer; $5 minimum
Foreign transaction fees
If you’ve stopped contributing to your investments because you no longer have the money to do so – and therefore have no other funds to redirect to your high-interest debt or credit card balance transfer – there is also a second option to consider before selling your investments. Instead, Molina advises using any available line of credit in your investment portfolio, which essentially means borrowing from your brokerage account. Many major brokerages offer a portfolio line of credit, including wealth front, M1Finance and Charles Schwab.
“If you sell investments to pay off debt, you will owe capital gains tax, which can be as high as 37% if you hold those investments for less than a year,” says Molina. “Taxes can seriously eat away at your returns.”
By taking out a loan through a portfolio line of credit, you can access the money from your investment tax-free. Borrowing from your wallet does incur interest, however, but it’s a good option for short-term financing needs (three to six months), such as accelerating the repayment of any high-interest debt.
Finally, whatever you do, avoid dipping into your retirement accounts if you plan to use your investments to pay off your debts. Withdrawals from your 401(k) are subject to regular income tax, and withdrawing early before age 59½ will most likely result in a 10% penalty. “[It] could have a significant impact on your ability to achieve your long-term financial goals,” adds Kalsman.
What about other types of debt?
Since these are usually low-interest debt, you don’t necessarily have to rush to pay them off, especially at the expense of selling your investments to do so. Plus, the interest you pay on a mortgage and student loan is tax deductible.
Kalsman adds that it may not make sense to apply excess cash to those debts if you’ve refinanced or taken out a new loan in recent years at great rates.
“Generally, you should prioritize debt from highest to lowest interest rate,” says Dunston. “If it’s below 4%, there’s an argument for keeping your money invested, but it can also depend on how it’s invested: high-growth portfolios or low-yielding accounts where you could lose money. money because of what accumulates in debt.”
At the end of the line
It is very rare that you sell your investments to pay off your debts. The only exception here is if you have high-interest debt (like an outstanding credit card balance), but even then there are alternatives to consider before using your investments as repayment.
At the end of the day, remember the reason for why you are in debt to begin with. While debts like student loans and mortgages are arguably smart to take on, high-interest credit card debt is something you want to avoid early on.
“Using an investment account to pay off debt can get you rid of high interest payments,” Kalsman says, “but it doesn’t avoid the main problem, which can be bad money habits (in some cases ), such as overspending or racking up credit card bills with impulse purchases.”
Editorial note: Any opinions, analyses, criticisms or recommendations expressed in this article are those of Select’s editorial staff only and have not been reviewed, endorsed or otherwise endorsed by any third party.