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Going back to college or starting a new business are two lifestyle changes that offer the potential to increase your future income potential, but they also require a large upfront investment.
In fact, investors under the age of 55 are likely to pay for their education or finance a new business using their investments, according to a survey by Select and Dynata. More than half of respondents aged 18 to 54 reported investing to finance a business, while more than half of 18 to 34 year olds and almost half of 35 to 54 year olds reported investing to pay for their education.
It seems that selling investments to fund these two expenses is pretty typical, but is it a smart move? Answering the question really boils down to whether it makes more sense to withdraw your investment earnings or borrow money instead.
“You have to understand what your percentage of interest is [would be] on your debt and ask yourself if you can do better in the market, ”CFP Bryan Cannon, chief portfolio strategist and CEO of Cannon Advisors, told Select.
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Should you use your investments to pay for your education?
Joe Buhrmann, CFP and senior financial planning consultant at Fidelity’s eMoney Advisor suggests that if the interest rate on the student loan – especially if it’s a federal student loan – is low and attractive, it may make more sense to hold onto your investments and borrow the funds instead. to pay for your studies. In this case, your market rate of return will likely be higher than the interest rate you would pay on your student loans.
Cannon wants investors to keep in mind that the markets over the past 20 years, which have seen two major bear markets at -50%, have seen average gains of over 8% per year (note that past performance do not guarantee future success). “As a general rule, especially in this low interest rate environment, it is not a good idea to cash in investments to pay for education or pay off school debt, especially for young investors who have a long horizon. of more than 10 years until they need access to their [investment] fund, ”he said.
Let’s use a hypothetical example to see how this might play out. Suppose you need $ 10,000 to pay off the credits for your final year of graduate school, and you decide to take out a student loan or dip into your investments to fund this expense.
If you left that $ 10,000 on the stock market, with the 8% average annual return identified by Cannon, after 10 years that investment would rise to $ 21,589 (assuming there are no additional contributions).
Meanwhile, the $ 10,000 federal student loan you would take out, on a standard 10-year repayment plan with an annual interest rate of 5.28% (the interest rate for unsubsidized student loans from Federal graduates, at the time of writing), would end up to a total of $ 12,893 after 10 years (assuming you’ve paid the minimum each month).
In that case, taking out a student loan to pay for college makes more financial sense than taking the money out of the market – you’d rather lose $ 12,893 than $ 21,589.
Stuck with a high interest private student loan and want to pay it off with your investments?
Consider refinancing your student loans with lenders like SoFi or Earnest first to get a lower interest rate before turning to your investment income. Both offer low rates, no set-up costs, flexible repayment terms, and protection against economic hardship. After refinancing, the lower rate may mean it’s worth keeping your money on the market.
Should you use your investments to finance a business?
However, the situation may look different when deciding whether or not to use your investments to start a business.
Take an unsecured A small business loan with no financial history could charge you a much higher interest rate and exceed the return you could expect on your investments, argues Buhrmann. In that case, you’d better sell some of your investments to start your new business. When we say this we mean investments other than your retirement fund. While you can take money out of your 401 (k) to start a business, you must first consider the implications it would have on your retirement if your business were to go bankrupt. In addition, you will have to pay income taxes and a 10% penalty if you withdraw money from a 401 (k) or IRA before the age of 59 and a half.
And if you have already have a small business loan and want to pay it back with your investments? “If you took out a loan when inflation was high and the loan had a fixed rate, it would make a lot of sense at this point to pay off the loan using your invested capital,” Cannon adds.
The key, he says, is to determine if the annual interest rate you pay on a loan exceeds the average return on your investments over a year.
Budding entrepreneurs take note
Remember that while a new business venture can potentially offer great long-term rewards, it also comes with a lot of inherent risks.
“If you put all of your investment into starting a new business, you won’t have anything to rely on except incurring debt,” Cannon explains. “It’s important to understand that in most cases the income doesn’t flow easily to the business owner in the early years. “
If you want to start your own business, be sure to take this into account by having some supplies on hand to survive those early years. “Low reserves of capital are often the number one reason new businesses fail,” Cannon adds.
So if you want to have a cushion in case things don’t go as planned, it may be a good idea to maintain a healthy emergency fund and not sell all of your investments.
At the end of the day, it’s more than just math
Weighing the potential return on your investments against the interest rate you would pay if you took out a loan is an effective way of knowing whether you should use your investments to pay for your education or finance a business. However, Buhrmann points out that ultimately there is no “correct answers“and what works for someone else may not work for you.
“There are mathematical aspects and also behavioral aspects. by all means, “pay in cash‘for the expense and sell some of your investments. “
If you’re thinking about cashing out a portion of your investment income to fund a lifestyle change, consider speaking with a reputable trust investment advisor who can act as a sounding board and advise you.
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Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.