Making Over Janet

Janet's savings [which she hopes to use for a condo] exceed her debt, and she suspects she's paying high interest rates on her loans while trying to decide what to do next. Fear of making the wrong step is paralyzing her, and she ends up doing nothing.

Most people think of debt and investments as distinct parts of their finances. They develop separate plans for each, seldom seeing them as alternatives along a single continuum. But whether you already have debt or are considering taking on new obligations, you should consider debt as another investment tool for your dollar.

Each dollar you have for investment (after you've paid your taxes and living expenses) should be put to work to your greatest advantage. You have choices: you can pay down outstanding debt, put the money into a savings account or invest in stocks or bonds.

To decide which is most advantageous, compare the expected rates of return, and the likelihood of realizing that return.

Crunch the Numbers

For debt, this is easily determined, because the expected rate of return is the interest rate, which is usually clearly stated. Payment of the interest is contractually required.

For example, if you have credit card debt at 18 percent interest, paying that down is equivalent to earning an 18 percent rate of return (with full expectation of earning that rate). Don't look to any savings accounts to achieve that kind of return.

Some debt is tax-deductible (home mortgages, home equity loans; some student loans). Savings accounts, corporate bonds and equity investments are also typically subject to tax. In order to do a proper evaluation, you have to compare apples to apples — when evaluating options for your money, make sure you adjust the various opportunities so that you're comparing after-tax rates of return.

What Janet Should Do

Since Janet is in New York, let's assume she is subject to 28 percent federal and 7 percent state and local taxes. Credit card debt is not tax-deductible, so her after-tax rate is the same as pre-tax (assuming 18 percent pre-tax, it's also 18 percent after-tax).

Janet also has student loans, which might be deductible (up to $2,500 for 2001). Assuming her interest rate on the student loan is 10 percent, it would have an after-tax rate of 6.5 percent.

She also has savings in a taxable account. Assuming that it earns 5 percent pre-tax, it is earning the after-tax equivalent of 3.25 percent.

Janet's has her savings earmarked for a down payment on a house. Mortgage loans are deductible, so, assuming she can get a 30-year mortgage loan for 7.5 percent, the loan will cost her 4.875 percent, on an after-tax basis.

Over the same 30 years that she has the mortgage, money invested in the Standard & Poor's 500 Stock Index might be expected to earn 10 percent pre-tax, or 6.5 percent after-tax.

Looking at all of the opportunities available to Janet, we can rank them, from most advantageous to least advantageous, on an after-tax basis:

credit card — 18 percent.

student loan — 6.5 percent.

S&P 500 — 6.5 percent.

mortgage — 4.875 percent.

savings — 3.25 percent.

Janet should pay off her credit cards completely, then pay down her loan (the loan is a guaranteed 6.5 percent return). After paying down her debts, Janet will have approximately $70,000 (of which approximately $60,000 is targeted for the down payment. This leaves her with $10,000 to invest.

Since she needs some emergency reserve, she is probably best off by keeping the money in her savings account (even though she is paying 4.875 percent after-tax and earning 3.25 percent after-tax).

If Janet is comfortable with the long-term risk associated with investing in equities and she has other sources for an emergency reserve, she would expect to earn significantly more money on the $10,000 by investing in a low-expense S&P 500 stock index fund.

One final reminder — it's not always about earning the highest return available. It's good to keep a liquidity reserve of say three-six months living expenses in a highly liquid savings or money market account. Fewer months if you are in a secure job or industry or if you have other resources, closer to six months if you don't.

Guest columnist Kacy Gott, CFP, is president-elect of the Financial Planning Association of San Francisco ( and a principal with Kochis Fitz, a wealth management firm in San Francisco, Calif. ( He's also an instructor in the Personal Financial Planning program at U.C. Berkeley extension.