Credit cards, auto loans, your home mortgage, student loans, HELOCs…. The list goes on.
Taking on debt is often called “leveraging.” Like a pry-bar, teeter-totter, or a baseball bat, leverage amplifies a force. In the case of money, using debt can amplify both the good
times and the bad. If used wisely, it can be a great tool available to most of us today. If used irresponsibly, it can wreck your financial future and send you into a tailspin, never to be heard from again. No, but seriously, it can be bad.
Loans (debt) have been around for thousands of years. It allowed business to begin, as farmers and business owners could receive capital to buy their machinery and pay it back as the earnings start flowing in. Enough of the history lesson, lets get you reading something applicable and useful to your life today:
So when is the right time to use debt, if at all?
Rule of Thumb: consider using debt for appreciating assets (example: home, business, student loan) and avoid taking on debt for depreciating assets (example: car, vacation, credit card balance, etc.).
One factor when considering debt is opportunity cost. If you’re buying a car and the interest rate on the loan is 20%, you probably want to pay in cash. Why? Because you probably aren’t going to earn 20% elsewhere. But, what if the loan is 1%? Even if you have enough cash on hand, you may consider taking the loan if you’re going to use the cash elsewhere and earn greater than 1%. “But you just said don’t use it on a car loan.” Ok, that is true most of the time. But the opportunity cost of paying fully in cash is the potential return you’re missing out on elsewhere.
Two common scenarios where debt is used are for cars and houses. Big ticket items where cash isn’t always available. Let’s take a look at how to best navigate each one:
Auto Loan Scenario:
You buy a car for $20,000 and only have $10k of cash to put down. You finance the remaining $10k over 5 years at an interest rate of 2%. This equals a payment of $175 per month for 60 months, or $10,516 total. So, you’re paying $516 for the convenience of getting that car immediately, rather than saving up for it. A 2% interest rate is pretty darn debt-friendly. Increase that interest rate to 5%? Your monthly payment increases to $188 and total interest paid becomes $1,322.
When does this make sense?
- You need the car right away. Having it now is worth the cost of the interest to you. Maybe its to get you to a job. Maybe the savings on repairs and maintenance relative to your ’92 Chevy Tracker more than make up for it. Maybe you’re trying to impress McKenzie Bezos on your first date. Whatever the reason, the car is worth $21,322 to you to have it now.
- If the interest rate is lower than inflation (typically ~2.5%), so things like your salary and any investment accounts are earning a higher rate of return than what you’re paying to the bank. Paying cash in-full will actually COST you money because you won’t have cash to invest elsewhere at a higher return than the interest rate on the auto loan.
Home Loan Scenario:
You buy a home for $1 million and put 20% down. So, you have an $800k loan over a 15-year term. The interest rate you get is 3%. Even if you have the full $1million, does it make sense to still have a mortgage?
You have 3 options:
Option 1: Use the mortgage and keep your extra $800k in cash
Option 2: Use the mortgage and invest the $800k
Let’s say you invest in a mixture of stocks and bonds, and earn a very modest return of 5% annually. (The stock market’s historical return over the last 90 years is an annualized 9.8%).
Option 3: Pay for the home in cash
Fast-forward 15 years:
| Option 1 (800k loan, no investment) |
Option 2 (800k loan, 800k invested) |
Option 3 (no loan, paid cash) |
|
| $800k: | Still $800k cash | Now worth $1.66 million. You’ve earned $886k in investment return. | N/A Paid for the home in cash. |
| Interest Paid on Loan: | ($194,000.00) | ($194,000.00) | $0 |
| Net Gain (Loss)* | ($194,000.00) loss | $1,470,000.00 gain | $0.00 |
| *+/- any change in value of the home. | |||
When/How to Pay if Off?
When paying down debt, pay-off the debt with the highest interest rate first. For many, this is student loans. Paying off $1000 in debt with a 10% interest rate is the same as investing $1000 and generating a guaranteed 10% rate of return. You may have heard… A penny saved is a penny earned.
What Else to Consider?
A fair amount of emotion goes into taking on debt. Some people want to avoid it for anything other than their home mortgage, and even that they want to pay off quickly. It keeps life simple and decreases stress. Debt is a burden they want to avoid. That is perfect for them and certainly admirable.
Others may have multiple investment properties with mortgages, business loans, etc. that they believe will all generate a net positive return. That is, the income generated will outweigh the interest paid. They view debt as a tool, rather than a burden. They’re looking to leverage their money, which is great too. They just need to remember that increasing leverage also increases risk. Things could go extremely well for them, but also extremely poorly.
Questions to Ask Yourself:
- Do you expect the asset to appreciate or depreciate?
- If able to pay in cash, what’s the opportunity cost of doing so? What else will I do with the money instead of paying in-full?
- What debt should be paid off first? Choose the highest interest rate first.. credit cards! Don’t take on credit card debt! These rates are sky high. Pay them off fast, or better yet don’t carry a balance month to month.
MoneyStuff 