This post is somewhat related to the last one, but it was mainly inspired by a conversation I had with one of the professors yesterday.
Aside from monitoring and reducing your consumption, the best thing you can do for your finances is to pay off your debts. If you have any debt, then all of your spare cash should go, before anything else, to getting rid of that debt. You should almost never* save money while you still have debts to pay off. Investing money while you still owe debts is a sure way to waste and destroy your money. You will always be paying more interest on your debts than you earn on your investments, after adjusting for risk.
To see why this is true, consider things from the point of view of the person who loaned you money. They have access to all of the investment opportunities you do. In the case of banks and other financial institutions, they have access to even better opportunities, and they will pay less fees. The reason they are lending money to you is that they are earning more money off of you than they could earn from any other investment. Think about that for a minute. You are paying the bank a higher interest rate, after adjusting for risk, than they could get from any other investment opportunity they have access to. It should be obvious that borrowing money from a bank to invest in the stock market is dumb. If you do so, you are claiming that you are a better investor than a collection of very smart people who spend their lives studying investments.
One basic lesson of Economics is that there is a single, risk-free interest rate in the economy. Any difference in interest rates that you observe comes from risk. If the interest rate for an investment is higher, then it will be more risky. Guaranteed. If you do not know where the risk is, then it is hiding in a dark corner somewhere and it will probably come out to bite you at the worst possible time. This risk-return tradeoff is the mirror image of the fact that a better credit score will get you a lower interest rate. You are less risky, so the lender accepts a lower return.
Differences in risk-adjusted interest rates cannot persist. If average returns are higher in the stock market, then banks and traders will buy stocks, pushing their price up and making their returns lower. If something has had high returns in the past, that does not mean it will have high returns in the future. If anything, it means that it is overpriced right now.
When you invest, you will, on average, get slightly less than the risk-free rate, because of transactions costs. Even with the lowest-fee index fund, you will pay a small percentage of your money each year. Conversely, when you borrow, you will always pay more than the risk-free rate. There is some chance that you will default, and the bank will charge you a higher rate because of that. If you borrow money and invest it, you are bleeding cash on both parts of the transaction. There is a chance you might get lucky, but it is just like gambling in the casino: the house always takes its cut, and on average you will lose.
Paying off your debts is therefore the best investment you can make. You get a guaranteed, risk-free return equal to the interest rate you were paying on your debt, and you get that return for an amount of time equal to what the lifetime of the debt would have been. If you have 25 years left on a mortgage with a 6% fixed rate, then paying off an extra $100 of that mortgage is like investing $100 in a perfectly safe bank account that will pay you 6% each year for the next 25 years. You will never find an investment that good anywhere else; that is at least 4% above the current risk-free interest rate.
If you have debts, the only reason to keep cash around is because you might need it in a hurry. You will probably want to keep a couple thousand in an easily accessible account, to handle your normal bills and things like unexpected car repairs or house repairs. It is worth losing the interest there to make sure you never have to pay credit card interest rates. If you have a bigger expense, like medical bills, then you can deal with that by taking out a home equity loan. If you have been paying extra on your mortgage, you will have plenty of equity to draw on, and you will have been 'earning' a much higher interest rate.
Despite this, a huge number of Americans routinely put money in retirement accounts or bank accounts or mutual funds while still owing debts. If you are one of those people, you need to change this today. Draw on any savings you can get without paying fees, and use that money to get rid of debts. It is the closest thing to free money you will ever see.
Of course, after you do this you have to make sure that you keep saving when the debt goes away. Immediately after you pay off the mortgage, take all the money you would have paid on the mortgage and have it deducted from your paycheck and put in your retirement account.
If you step back and look at things from an outside view, it is really strange that anyone would be a borrower and a lender simultaneously. It just does not make sense. And yet, we have a culture that considers this bizarre situation to be normal, expected, and even proper. The end result of this is that the financial industry makes massive profits. They lend money to you at high rates, and you turn around and lend it back to them at low rates. When future generations look back on our society, they will probably see this as obvious folly and they will wonder why everyone fell for it and why society encouraged it.
If I have convinced you, you can stop reading now. Go pay off your debts, if you have any spare cash. If you don't have any debts, remember to pay for your next car in cash, drawing down your savings to do so. If you still don't believe me, keep reading. I'll go through the objections that people bring up to debt removal.
I had assumed that what I just said was known to all Economics and Finance professionals. But yesterday, as we were talking about financial regulation and the housing crisis, a professor said that nobody ever needed to pay extra on mortgages. When I pressed him, he said that it would sometimes make sense to borrow money to invest in the stock market. Here are some of the things that came up in the discussion:
"Why are you encouraging people to invest more money in their house, rather than getting a balanced portfolio?"
Paying off your mortgage is not investing more money in your house. You are already the owner of your house, and you are legally obligated to pay off that debt. Unless you plan on walking away from your mortgage and ruining your credit, you will have to pay all that money sooner or later. You are stuck with the house until you sell it; the asset allocation decision has already been made. The choice is between paying off a debt or investing money.
There is no reason to keep a 'balanced portfolio' until you have no debts. The whole purpose of a balanced portfolio is that is always has a good return, no matter what happens to any particular investment. The holy grail of investing is to construct a portfolio that always gives a decent return, no matter what the economy or anything else does. Paying off your debts gives you exactly that, at a higher rate than you can get elsewhere.
"In the past, stocks have earned high returns on average. If you keep and hold them, you will get more than paying off your mortgage."
It is true that, since 1950, the total real returns on stocks has been about 7%. But during that time, the interest rate on mortgages was higher. Aside from a few odd years, anyone who put money in stocks while still paying off a mortgage would have lost a lot of money. Low mortgage rates are a very recent thing, and they are only going down because all interest rates have been going down in recent years. When interest rates are lower, returns on stocks will also be lower. The future return on stocks will probably be less than 7%. Again, the bank could invest all their spare cash in stocks if they wanted to, and they are only loaning money to you because they know that you are paying more interest than they can get in the stock market.
"This would mean not putting away any money for retirement until you pay off your house."
I can guarantee that a person who pays $1000 a month on their mortgage and puts $500 in a month a retirement fund will be in worse shape than someone who pays $1500 a month on that mortgage. The latter person will have the mortgage completely paid off in 13 and a half years rather than 30, and can then start putting $1500 a month into the retirement savings. The actions of the person who kept the mortgage and the retirement account at the same time are identical to the actions of someone who borrowed $500 a month from the bank and put it in the stock market.
"The interest I pay on my mortgage is tax-deductible, so the actual interest rate is lower"
Any profits you make on your investments will be subject to capital gains tax, so the actual return there is lower too. The capital gains tax rate is probably lower than your marginal tax rate, but that difference is not nearly enough to make up for the fact that you are paying more than the risk-free rate.
* It sometimes makes sense to keep debts that are heavily subsidized, like student loans, or put money into an employer-sponsored retirement plan with matching funds. Also, if you got a fixed-rate mortgage in the past, when rates were low, and rates are much higher today, than it makes sense to save rather than pay off the mortgage. But aside from that, you should never invest anything while you still have debts.