Published September 25th, 2017
This is a guest contribution by Jacob from Dollar Dilligence. You can find him on Twitter @DollarDiligence for more personal finance articles and advice.
Cash comes in, cash goes out.
What you do with that cash, though, can make all of the difference in your financial outlook.
One great option is to invest that cash in stocks that result in dividend payments. You can earn cash inflows by owning dividend stocks, but does this mean it’s automatically the best option for consumers?
It is important to remember that some (or all) of that money could be spent on paying down debt, if applicable. Debt can be crushing, and often causes many problems, emotionally and mentally, for consumers. Paying it off not only improves consumers’ lives financially, but also in general. Being debt-free is an amazing feeling, especially when you have dealt with it for years.
The hard decision that people have to make every day is whether they should use their money to buy stocks or to pay down debt.
Like many things in life, it depends. Let’s take a look at when each strategy makes sense.
Generally, stock investors fall into two, sometimes overlapping, camps: Those who are looking to make money on share price increases and those who want a steady stream of dividend income.
Many stocks pay dividends, which are a share of a company’s profits. Many other stocks don’t pay dividends – all profits are plowed back into the company or are used by management to repurchase shares. Dividend stocks usually make quarterly payments, though the final say is left to the board of directors.
The ratio of annual dividend payments per share divided by the current stock price is called the dividend yield, and naturally, the higher the yield, the more cash you’ll receive with each quarterly dividend check. For example, a stock that sells for $20/share and pays an annual dividend of $1/share has a dividend yield of $1/$20, or 5 percent.
A few basic points about dividend investing:
- Preferred stock pays higher dividends than do common stocks (on average). Dividends for preferred stocks must be paid out in full before common-stock dividends can be paid.
- Most American-company dividends are “qualified,” which means the payouts are taxed at the long-term capital gains tax rate (currently 20 percent or lower).
- Stocks that pay large dividends usually have a more stable price than do other stocks.
- Dividends are not guaranteed – they can be raised, lowered or omitted. Some preferred shares must repay previously omitted dividends before common-stock dividends can be paid.
- Currently, the S&P 500, an index of large stocks, yields about 2 percent.
- Utility, food, and other “boring” stocks typically pay above-average dividend yields.
- Growth companies pay little or no dividends.
American Consumer Debt
We Americans use debt to improve our lifestyles. Credit cards allows us to buy things without having all the cash up front. The average American household owes more than $8,300 in credit card debt, which adds up to more than $1 trillion, up 6 percent in 2016. Those with excellent credit can obtain credit cards that charge about 10 to 15 percent interest. However, those with poor credit might pay up to 30 percent annual percentage rate.
American student loan debt is even larger, equaling $1.4 trillion in 2017 distributed among 44 million borrowers. The average 2016 graduate owes more than $37,000 in student loan debt, with an average payment of $351 per month. The average delinquency rate is 11.2 percent. Federal student loan interest rates, which are fixed, range from 3.76 percent to 6.8 percent. Private student loan rates are generally variable and higher.
Cash Management Strategies
So, is it better to invest in a dividend stock portfolio or pay down debt?
- Dividends vs credit card debt: The decision should be made on an after-tax basis. If you pay 20 percent tax on your dividends, then a 5 percent before-tax yield equals a 4 percent after-tax yield. Credit card debt is not tax deductible. If you have excellent credit and your after-tax dividend yield exceeds 10 percent, then you can make a case for favoring stock investing. However, most folks would do better paying down debt, because credit card interest rates are generally higher than dividend yields. Another factor is risk: Dividends can be cut, and dividend-stock prices can fall. In other words, your return on dividend stocks is not guaranteed, but you are guaranteed to be on the hook for 100 percent of your credit card debt.
- Dividends vs student loan debt: This case is more complicated, because federal student loan rates are as low as 3.76 percent. That’s a lot lower than credit card interest rates, so there is little reason to favor repayments over investments. However, you might have private student loans that charge 7 percent, 8 percent or more. Your decision therefore hinges on the student loan interest rate you pay. Another consideration is your monthly payout. If you owe considerably more than the average, your monthly student loan payments might exceed $1,000. In this case, you might want to pay down the debt so that you have more money each month for other purposes.
Every individual situation is unique, but it might be fruitful to consider paying down your debts first and then investing for income. Note that mortgages are different, because the interest is tax deductible, so make sure to compare after-tax rates.
Whatever your case may be, try to sit down and map out your debt and potential investments. Would you be better off paying down all of your debt then worrying about investing later? Or, would it make sense to invest while paying down your debt?
The case can be made for both, and it is important to consider the non-financial impact of each as well. Sure, financially it may make sense to pay down debt and invest at the same time, but if that means you will be stuck with your debt for another ten years, then maybe you opt to pay off your debt faster so you can escape the anxiety it causes.
Either way, your best bet is to try to understand the ins and outs of your situation and make a plan and stick to it.