Over my two short years as a young adult, I have come to the realization that there are two main ways to pay off debt. One can just make the minimum payments every month and do whatever with the rest of the budget – sometimes that’s all we cay afford – or pay way more than that with the intent to have the whole amount paid off as fast as possible. I am a firm believer that if our income allows the second option, it is by far the better one. Here is why.
Leveraging and how it’s being misused.
Most proponents of the minimum payment method usually argue that they would rather invest than write a fat paycheck to the bank. Other than credit card debts whose interest rates are too high for such a strategy to work, it would seem like a smart way to approach things, except that it’s not, because most people simply don’t invest enough to offset their interest payments.
When it comes to investing, “leveraging” is an investment strategy that involves using borrowed money with the goal of achieving a return higher than the interest. My main issue with this is that way too often people seem to misinterpret or ignore the investing part and think they can worry about it later, or maybe do it little by little.
The reason is pretty simple. That strategy only works if there’s ACTUALLY money left to invest after the minimum payment. Unfortunately, most people that I know buy the item with the highest minimum payment they can afford. In other words, we do not typically borrow because we want to invest our capital. We borrow because we want to drive a nicer car or live in a bigger house than we can afford with cash.
Let’s say an individual named John goes to the car dealership with $10,000 in his pocket. He could either buy a $10,000 car and pay with cash or buy that same car on credit, using a down payment and investing the balance in a stock market index fund. If he planned to pay the car off in say 7 years, most of us would think of it as a reasonable strategy. The S&P 500’s average historical return points to the investments doubling on an average of a little more than 7 years. In most cases, John would have more money after these 7 years than if he had made an all cash purchase.
The problem is that if John is the typical consumer, he probably would go a different route. He would determine how much he could afford to pay off per month and that would usually lead him to a car that is much more expensive than the $10,000 he has in cash. John would still put the full 10,000 down, but let’s say he bought a $33,000 car – an average price according to Kelley Blue Book. He would be stuck with years of sky high payments that left little room for investing. In many cases, John would only be able to manage the minimum payments.
For the sake of argument, let’s say he’s really good at budgeting and keeping his expenses low, so he still manages to put $200 a month towards his investments. Assuming a 7% return, these investments would easily offset the car loan if he was able to get a “good” interest rate. Currently, they seem to be revolving around 4%. Even after one full year, that’s only $2400 earning him a return. The loan balance would still be a lot higher than that, with no funds in the market to offset the interest. The net result is still a loss of money.
To put it bluntly, earning 7% on $2400 is not a good deal when there’s still nearly 20 grand borrowed at 4%.
Investing can mathematically be better than accelerating the debt pay off schedule. Regardless of this fact, the most important thing for John is to buy a car he can pay for in cash. Actually paying the full price outright or deciding to invest some of it is a personal decision. As long as he has the amount in cash at the moment of purchase he should be fine.
I myself would much rather go the debt free route because I’m a risk averse person . I will go into that later in this post.
The logic described with the car also applies to buying a house. In fact, it becomes even more obvious due to the way bigger loan amounts. In the car scenario, it might take John 2 or 3 years to have his investments catch up with the loan balance. For a house, we might be talking decades. Obviously that’s not the only deciding factor when buying a house as it’s usually an appreciating asset and the dynamics completely change because of that. I’m just using the house here to further illustrate my theory.
My main point here is that yes, borrowing money at a low interest rate in order to invest capital can be a perfectly logical strategy, but most people don’t borrow with that mindset; I am of the opinion that the typical american consumers borrow to buy stuff they could not otherwise afford. Investing capital only works if there is actual capital to invest. As soon as we purchase an item with a price tag that’s higher than what we have in cash, we are no longer in the investing game, we are in the monthly payments game.
Putting down some cash and investing the rest can work, but buying more than we have in cash leaves no room for investing.
Now Let’s switch things up a little and take a look at Student Loans.
Student loans are a little trickier. Although I believe we should avoid them at all costs (i.e. consider going to a cheaper school, work while in school), I realize some people just have no better option. Click here for tips on how to make college more financially manageable.
Where we get to have some control is after we graduate and start earning money. Again, people approach student debt in one of 2 ways. Either they try to pay it off as fast as possible or they just pay the minimum every month for 10 years or so. If you made it this far in the post, there’s no need to mention which group I side with.
Beyond my natural hatred towards debt of any kind, let’s take a quick look at the numbers. The average public student loan interest rate is between 3 and 4%. The cheapest I’ve heard of is around 3%. I’ll ignore private loans as their near double digit interest rates make it a no brainer to treat them like credit card debt, so back to public loans.
With a 7% return and a 3% interest rate on the debt, that leaves us with a 4% net return. Will we end up making money? Sure. Is the return worth the risks that come with staying in debt? NO! We’re barely keeping up with inflation.
In both the car and the student loan cases, the risk caused by staying in debt is greater than the reward.
For example, imagine losing our income for an extended period of time. One of the options would be to tap into the investments that were accumulated through leverage. That sounds nice except that the market could be taking a beating at the same exact time. Touching that money would put the whole plan in shambles.
As a result, I think a legitimate argument can be made that attacking debt as fast as possible can make sense mathematically. Paying off debt not only makes off feel good, but it can also make us richer. The faster the debt is paid off, the faster we can start putting ALL our money towards investments without having to touch them ever.
- Leveraging only works when there’s actual capital to invest. If you’re borrowing $10,000, you need at least $10,000 invested somewhere that can earn you a return higher than the interest.
- The returns caused by leveraging can be overrated.
- Although great in the long run, investments often present short term risks that debt merely accentuates.