I will retire at the end of this year. I’m trying to decide between two choices on how best to use $40,000 that I plan to have as extra money by the end of the year. My only debt is a car payment, about $40,000. Or, I can use the $40,000 to buy more dividend-paying stocks to add to my portfolio. My dividend portfolio will eventually pay off the car loan and the dividends will continue, whereas if I pay off the loan, I won’t have any additional dividends in the future.
-Chris
I see two points of discussion here. The first is the decision to repay debt or invest. This is a classic problem, but I will point out some things that I would consider in your case. Next, you will need to determine if investing in dividends is the best option for producing retirement income. (And if you need help making important financial decisions, like investing or paying off debt, consider working with a financial advisor.)
Invest or repay debt
Comparing the interest rate on your auto loan to what you expect to earn on your investment is the most common way to approach the question of whether to pay off your debt early or invest the extra money. That’s usually where I start too.
The lower your interest rate, the more it makes sense to invest the money. For example, if your car loan has an interest rate of 2%, your investments can easily earn a higher return, making the investment the better choice.
But what if your car loan has an interest rate of 15%? You’d probably be better off getting rid of that debt. Obviously, most car loan rates will fall between these two extremes.
When making this decision, it is also important to keep volatility in mind. In most cases, the interest you save by paying off the debt is fixed and guaranteed. In other words, you know what you’ll save. On the other hand, investment returns can often be quite volatile. Due to the possibility of low or even negative returns in any given year, it may take several years for your investment returns to exceed the money you would save by paying down your debt. (And if you need more help with your financial plan, consider working with a financial advisor.)
However, it’s not all about math. Remember to consider your own preferences, risk tolerance and budgetary considerations. Additionally, here are some equally important thoughts to ponder:
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If you repay a debt, the cleared payment is immediately available in your treasury. With an investment, you have a time horizon and volatility to consider.
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For many, paying off debt has significant psychological or emotional benefits.
Investing dividends for retirement income
Since we haven’t met, I don’t know how much you have considered the idea of investing in dividends for retirement income. You may have done extensive research and are completely comfortable with this strategy. If not, it’s important to point out some of the common misunderstandings about dividend investing. To be clear, I do not encourage retirees to rely on dividends due to several shortcomings:
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Dividends are nothing more. They are an integral part of a stock’s total return. Spending dividends means reducing future growth.
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They are both tax and cash inefficient. When your portfolio is dividend-centric, you hamper your ability to plan your tax obligations and cash flow.
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Companies that pay large dividends are often very similar. These companies share very similar characteristics with each other. When your portfolio is loaded with dividend-paying stocks, you’re likely to be much less diversified than you should be.
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Dividends are not guaranteed. Companies must have profits to pay dividends, which they can stop.
Dividends aren’t bad, and I’m not suggesting that you should avoid dividend-paying stocks altogether. I just think there’s less strategy than common history often suggests. (And if you need help finding financial advice, this tool can help you find potential advisors.)
Conclusion
Compare the interest rate on your car loan and the return you expect from your investments. Also consider your time horizon, risk tolerance and effects on your budget. As for dividend investing, I encourage you to take a critical look at this approach.
Tips for finding a financial advisor
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Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three approved financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
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Consider a few advisers before settling on one. It’s important to make sure you find someone you trust to handle your money. When considering your options, here are the questions you should ask an advisor to make sure you make the right choice.
Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers readers’ personal finance and tax questions. Do you have a question you would like answered? Email AskAnAdvisor@smartasset.com and your question might be answered in a future column.
Please note that Brandon does not participate in the SmartAdvisor Match platform and was paid for this article.
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