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Returning to higher education or starting a new business are two lifestyle changes that provide an opportunity to raise your future income potential, but they also require a large upfront investment of money.
In fact, investors under 55 are likely to pay for their schooling or fund a new business venture by using their investments, a survey by Select and Dynata found. Over half of respondents aged 18 to 54 reported that they invest to fund a business, while over half of 18- to 34-year-olds and nearly half of 35- to 54-year-olds said that they invest to pay for school.
It seems that selling investments to fund these two expenses is quite typical, but is it a smart move? Answering the question really boils down to whether it makes more sense to cash in on your investment gains or borrow the money instead.
“You need to understand what your percentage of interest [would be] on your debt and ask yourself if you can do better in the market,” CFP Bryan Cannon, chief portfolio strategist and CEO at Cannon Advisors, tells Select.
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Joe Buhrmann, a CFP and senior financial planning consultant at Fidelity’s eMoney Advisor, suggests that if the student loan interest rate — especially if it’s a federal student loan — is low and attractive, it may make more sense to retain your investments and instead borrow the funds to pay for school. In this case, your rate of return in the market is likely going to be higher than the interest rate you’d pay on your student loans.
Cannon wants investors to keep in mind that the markets over the last 20 years, which experienced two significant -50% bear markets, have averaged gains of 8%+ per year (note that past performance does 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 school or pay off school debt, especially for younger investors who have a 10-plus year time horizon until they need access to their [investment] funds,” he says.
Let’s use a hypothetical example to see how this could play out. Say you need $10,000 to pay for credits in your last year of grad school, and you are deciding whether to take out a student loan or to tap into your investments to finance this expense.
If you left that $10,000 in the stock market, with the average 8% annual return Cannon identifies, after 10 years that investment would grow to be worth $21,589 (assuming no additional contributions).
Meanwhile, the $10,000 federal student loan you would take out, on a 10-year standard repayment plan with an annual interest rate of 5.28% (the interest rate for federal graduate unsubsidized student loans, at the time this article was written), would end up costing a total of $12,893 after 10 years (assuming you paid the minimum each month).
In this case, taking out a student loan to pay for grad school makes more financial sense than withdrawing the money from 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 using your investments?
First consider refinancing your student loans through lenders like SoFi or Earnest to score a lower interest rate before turning to your investment earnings. Both offer low rates, no origination fees, flexible repayment terms and economic hardship protection. Once you refinance, the lower rate may mean it’s worth keeping your money in the stock market.
Should you use your investments to fund a business?
The situation, however, may look different when deciding whether or not to use your investments to launch a business.
Taking out an unsecured small business loan without a financial track record could leave you paying a much higher interest rate and it could exceed the return that you might anticipate on your investments, Buhrmann argues. In this case, you could be better off selling some of your investments to jumpstart your new venture. When we say this, we mean investments other than your retirement fund. While you can withdraw money from your 401(k) to start a business, you should first consider the implications that would have on your retirement if your business fails. Plus, you’ll have to pay income taxes and a 10% penalty if you withdraw money from a 401(k) or IRA before age 59½.
And if you’ve already taken out a small business loan and want to pay it off using your investments? “If you took out a loan while inflation was high and the loan had a locked rate, it would make a lot of sense at that point to pay the loan off using your invested capital,” Cannon adds.
The key, he says, is to determine if the annual interest rate you are paying on a loan exceeds the average return on your investments in a year.
Budding business owners take note
Remember that although a new business venture can potentially offer big rewards in the long run, it also comes with a great deal of inherent risk.
“If you sink all of your investments into starting a new business, you will have nothing to fall back on aside from acquiring debt,” Cannon says. “It is important to realize that, in most cases, income is not readily flowing back to a business owner during the first several years.”
If you’re wanting to start your own business, make sure you account for this by having reserves on hand to survive those first few years. “Low capital reserves are often the main reason why new businesses fail,” Cannon adds.
So, if you want to have a cushion in case things don’t go to plan, it can make sense to maintain a healthy emergency fund and not sell all of your investments.
At the end of the day it’s more than just the math
Weighing the potential return on your investments versus the interest rate you’d pay if you took out a loan is an effective way to know if you should use your investments to pay for school or fund a business. However, Buhrmann points out that at the end of the day there are no “right answers” and what works for someone else might not work for you.
“There are mathematical aspects and also behavioral aspects,” he says. “Math and finance might dictate that you should borrow the money to finance the endeavor, but if you’re going to lose sleep or it impacts your health by taking on debt, then by all means, ‘pay cash‘ for the expense and sell some of your investments.”
If you’re someone who is thinking about cashing in some of your investment earnings to fund a lifestyle change, consider speaking with a reputable fiduciary investment advisor who can act as a sounding board and provide guidance.
Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.