An interesting question was raised by a friend of mine regarding the best way to spend his dividend income. As the question made its way around the table, it grew into a debate, then progressed into an outright argument.
It seems people can get very emotional over their stock market strategies and methodologies. One member even recounted that he was so thrilled with his dividend gains that he borrowed money to beef up his stake in the stock.
The discussion quickly divided the group of six into two evenly split camps: those who favored focussing on dividends and reinvesting those dividends for compounded growth, and those who favored focussing on paying down debt instead of dividend reinvestment.
The arguments are worth considering, since there are two common fallacies in need of being dispelled: one involving debt, the other involving compounding.
Fallacy #1: Never Borrow to Invest in Stocks
Professional financial planners and advisors mean well when they caution investors not to borrow money to invest in stocks. For the most part, their warning is well founded, since the interest charged on your debt will almost always be greater than the dividends you collect from your investment. What is more, if you pick the wrong stock, you could end up losing 50% or more of your investment, while still owing 100% of your borrowed debt.
But making it a hard fast rule to never borrow to invest in stocks is a little extreme. In fact, the entire provision of margin is intended to facilitate borrowing for the purchasing of stocks. If you are investing in a solid dividend payer the likes of telecom giant AT&T (NYSE: T) or gas utility ONEOK (NYSE: OKE), which are paying dividends of 5.4% and 5.1% respectively, then buying some shares on 50% margin would effectively double your dividend yield to over 10% per year while incurring perhaps only 2 to 3% per year in margin interest (depending on your broker’s interest rates).
One can also purchase a major index on margin if they are convinced the overall stock market will continue its bull run to new highs over coming years. The S&P 500 index, for instance, has already risen 210% in six years since the economic recovery began in March of 2009, averaging some 35% per year. As long as you haven’t been paying 35% per year in interest on your borrowed money, then borrowing money at the depth of the financial crisis in 2008 to stock-up on a cheap S&P 500 ETF would have been a very smart decision.
But while it is ok to borrow money to purchase “certain” stocks, we should be careful not to gamble on just any stock that catches our eye. Borrowing money to purchase something volatile like Tesla Motors (NASDAQ: TSLA) or Netflix (NASDAQ: NFLX) would be flirting with potential disaster whenever those stocks enter one of their notorious corrections.
There is really only one way that borrowing money to invest in a stock can be justified, and that comes down to rates: that is, dividend yield and capital gains on the one side versus interest expenses on the other. You need to be certain that you are generating more from your dividends and/or capital appreciation than you are paying in interest on your borrowed money.
Elementary? Not really. Remember that 20% of dividends are taken away from us right from the top through the Dividend Withholding Tax. Of the remaining 80%, we then need to pay income tax which can measure some 25% depending on where we live. This means we are left with just 60% of the dividend paid. A stock like AT&T yielding 5.4%, therefore, ends up paying us only 3.24% free and clear.
If the interest you are paying is less than 3.24% per year, then you’re in business. If your loan is costing you more, then the financial planners are quite right in their warning not to borrow to invest in stocks.
But what about compounding? If we reinvest our dividends, wouldn’t the growth through compounding over the years make carrying debt worthwhile even at a high interest rate? That’s our next fallacy.
Fallacy #2: Compounding Gives Dividends an Advantage Over Debt
One of the arguments passed around the table during the above noted discussion was that rolling dividends into new shares for compounding returns is an advantage that makes carrying debt a smart investment strategy. The idea is that using each dividend payout to purchase additional shares essentially gives you free shares of stock which increases the amount you collect in dividends at the next payout. And while your dividends keep growing each quarter, the loan payment on your borrowed money stays the same, resulting in a growing profit.
Yet, that is true. Rolling dividends into new shares will increase the amount you collect in dividends at each future payout. However, the benefit of compounding is also available by paying down your debt. If you were to take your dividend payout and put it toward your debt, you would be saving interest not only on next month’s interest payment, but also on every interest payment for the duration of your loan, since your principal would be lower, and would thus incur less debt each and every month.
Thus, any payment made on your loan offers you a compounding benefit through saved interest each and every month, just as rolling your dividends into new shares would give you a compounding benefit through additional dividends each and every quarter.
Compounding, therefore, should not be a factor when determining where to put any extra money, whether to reinvest it in dividends, or whether to make an extra payment on your debt to reduce interest expenses. The benefit of compounding is made available by both dividend stocks and debt repayment. Compounding is a mute point, since it is available to you in both options – dividends and debt repayment.
Chasing the Higher Rate
The discussion we had that day ended on a rather amicable note, thankfully, with all parties surprisingly coming to a unanimous agreement: any extra money you have, whether through a dividend payout or some left-over cash from your paycheck, should always be put toward the option that carries the higher rate.
That is, if your dividend stocks are paying more than the interest costs on your debt, then the extra money should chase the dividend. If the interest you are paying on your debt is more than the dividends you are collecting, then the extra money should be put toward your debt. In this way you will ensure that your extra cash is earning the best possible rate available to you.
And the same applies to credit card balances, for that matter. It really does not make any sense having money in a dividend stock that pays 5% per year in dividends when you are carrying a balance on your credit card that is costing you 18% per year in interest. In this case, since the interest on your card is much greater than the dividend yield of your stock, your next bit of extra cash would be earnings 18% per year if you slapped it down on your credit card. That makes paying down your credit card debt is one of the best returning investments anyone could ever make.