The Debt Myth
Let me tell you the real story about debt …
How to use this chart:
Debt is only GOOD or BAD *before* you acquire new debt.
=> this helps you decide what debt to acquire [columns]
All debt you already have is *only* CHEAP or EXPENSIVE.
=> this helps you decide what debt to retire [rows]
Now read the article to learn more …
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Financial ‘gurus’ like Dave Ramsey, David Bach, and (ignoring the ‘get rich quick’ shysters) almost every single one of the others will tell you:
- Never take on debt (perhaps, aside from taking out a mortgage), and
- If you do, pay it off as quickly as possible - I mean … like … now!
So, if you look at the chart above - which will tell you everything you need to know about debt - you will notice one anomaly:
Only three out of the four boxes say to PAY OFF your debt …
… one says to KEEP it.
More on that later, but for now, here is the missing link … the one piece of information that you need to know, and all those ‘experts’ seem to have forgotten.
A penny saved is a penny earned.
So simple that I bet you learned it when you were a child, right?
Yet, almost every single book on personal finance just ignores it …
Make no mistake, books or no books, this is probably the most critical lesson in investment that you can learn.
So, let me give you a quick example to make sure its message is clear:
Let’s say, thinking back to when you were a child, that you have $1.00 in your pocket; and, this week you earn 50 cents pocket money and you buy 50 cents worth of candy, so you still have $1.00 in your pocket at the end of the week.
What if you also had two opportunities to choose from:
- Work an extra hour tidying up your father’s shed, and he’s offered you an increase to 60 cents pocket money this week for doing so, earning you 10 cents more?
OR
- You can instead choose to spend that hour shopping with your Mom at Costco, where you can now buy the same candy for only 40 cents, saving you 10 cents?
Fortunately, your choice won’t come down to money because, in both cases & at the end of the week, wouldn’t you now have $1.10 in your pocket?
See? 10 pennies saved is exactly the same as 10 pennies earned!
Seems simple, but this is actually so profound that it drives every decision of every professional investor because, when translated into the simple language of investing, it says:
Interest saved is interest earned.
To explain, let me give you another example:
You have received a $10,000 windfall [thanks Aunt Agnes, we’ll miss you!]; and, you’re smart enough not to blow it on a car or an overseas vacation, so … what would you choose?
- You have $40,000 left on a 30-year fixed-mortgage with 20 years left to run at 4%, but your bank will allow you to make a one-time special payment of $10,000.
OR
- Your bank manager gives you an almost conspiratorial wink and tells you that he also has 20 year bank-guaranteed bonds paying 4% compounded, only for his best investor-customers, for minimum deposits of $10,000 (welcome to the Big Time!).
You don’t need to run the numbers through a special calculator; in both cases the answer is the same:
You either save or earn approx. $22k
In reality, to make such a close choice, you would need to take into account a lot of factors, most critically: risk and tax.
Fortunately, most personal financial decisions that you make won’t be anywhere near that close or that complex, and that where my chart comes into play.
Here’s how to use it like a pro:
Part 1: Acquiring Debt
Good/Cheap
Check out the top/left quadrant; this is the classic good versus evil equation applied to debt, but this chart will save you from armchair philosophy, and bring you right back to financial common sense:
Robert Kiyosaki in his book Rich Dad Poor Dad defines
- an asset as something that puts money in your pocket, and
- a liability as something that takes money out of your pocket
We’re going to use this definition to help us decide whether to take on a debt:
- You want to buy a house; well, it doesn’t directly put money in your pocket, but it does stop you from paying rent (which is tantamount to the same thing, as we’ve just learned, right?). Which is why it’s in the ‘good’ column.
- Mortgage loans are also very cheap right now, around 4% in the USA, so that puts it squarely in the ‘cheap’ row.
Hey, so are some Student Loans: low interest rate, and they help you earn a living … sounds like we should go right ahead and load up on those, too?
[Disclaimer: if that’s the only way you can get that important qualification!]
So, anything in the Good and Cheap (top/left) quadrant of our chart is OK by me … go ahead and take out that mortgage, or that student loan; but, only if you can comfortably afford the repayments and really need to borrow the money to get it and you need it right now.
Good/Expensive
Which brings us to the murky world of the bottom/left quadrant:
There’s a lot of stuff that we want to buy, but can't afford, so are tempted to put on our credit cards … don’t.
But, very occasionally, there’s stuff that we have to buy for our education or our jobs that we simply don’t have the cash for.
What do we do then?
Let me give you an example, you’re a college student and your laptop has blown its cork … you don’t just want a new laptop (don’t we all?), but now you need one.
In fact, you won’t be able to complete your assignments without one.
Of course, you’ve already tried every beg/borrow alternative or we wouldn’t be having this discussion. And, we’ve already established you don’t have the money.
So, go ahead and borrow in the best (i.e. lowest interest) way possible, but if that means buying it on your credit card … well … that’s what you’re gonna have to do.
Same with a car.
Bad/Cheap
You’d have to be an idiot to finance a car, even if it’s on one of those top/right quadrant ‘zero interest’-type deals …
… c’mon, you know it’s a scam and you can always get that exact same car MUCH cheaper if you don’t take those huckster-finance deals.
The reason is, cars not only don’t put money in your pocket, they depreciate as soon as you drive them out of the lot. So, only buy cars if you have the spare (!) cash.
But, like the laptop, if you need that car to earn a living, and there’s no way around it … and, you don’t have the cash … do what you gotta do.
Bad/Expensive
So, that leaves us with buying stuff on our credit cards; terrible because it all turns to crap, and we eventually end up selling it on Craigs List or giving it away … yet, we’re still stuck with the credit card bills!
Still, I know people who’ve started their businesses on their credit cards, so there’s no black and white … at least not without our helpful chart :)
Part 2: Retiring Debt
So the Good/Bad rows will help you navigate the complexities of when and what type of debt to acquire …
… but, once you have debt, it is no longer Good or Bad, it is just Cheap or Expensive.
And, this is where we want to ignore all the ‘gurus’ and start to think like professional investors:
If interest saved is exactly the same as interest earned, then we should pay off our most expensive debts first:
Expensive Debt
This will invariably be credit cards; at 19% and up, paying off a credit card balance is exactly like earning 19% interest … but, without the risk.
So, go ahead and do it - pay off your credit card debt - as quickly as possible!
In fact, it’s totally worth your while to bust a gut to do so; whatever sacrificies you need to make, make them: go without your lattes; don’t go out for a month; sell your sister or your cat (or, your sister and your cat) … but, not your laptop, if you still need it for college or work.
The same goes for your car loans, which are probably > 10% (true cost), once the “interest free” period is over (if you were silly enough, or desperate enough, to fall for that scam) … in fact, put money aside now, to help you smash those loans when the time comes (i.e. the ‘interest free’ period is over).
Same for your “2 year interest free” [gah!] furniture and consumer technology loans.
And, your high interest student loans.
If you’re still not sure why, go ahead and plug a couple of numbers into a compound interest financial calculator like this one and see how much you can save by paying these loans off early.
It’s probably $4,000 or $5,000 on a $10,000 loan … not the interest (no, the interest will probably be more than the whole car cost you to take it off the lot), just what you can save by reducing the interest. Wow, huh?
Cheap Debt
Congratulations! You’ve paid off all of your credit cards and the TV is finally paid off as well …
What you are now probably left with is your mortgage and maybe some real low interest (not, those scummy “low” or “zero” interest car, TV, and furniture loans that we already spoke about) student loans.
And, they could be as low as 3% to 4% (for your 30 year fixed-rate mortgage, depending on when you took it out) or even 0% to 2% for that subsidised student loan
[Disclaimer: just watch out for the fine print, particularly on your student loans, and make sure the loan’s interest rate/fees can’t suddenly balloon, in which case, treat it just the other expensive debts and pay it/them off asap!]
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By now, you’re probably used to your austere lifestyle and figure you’ve got nothing better to do with your money, so you’re thinking that you may as well pay off these loans as well …
Don’t. Do. It.
This is where you you [financially] grow up.
This is where you move from Saver to Investor.
This is where you decide to become wealthy (well, wealthier).
This is where you remember that interest saved is the same as interest earned: and, that they both, if done right, can put money in your pocket.
You only pay off debt (i.e. to save interest) if there’s nowhere better for you to invest your money (i.e. to earn interest) …
… and, when your mortgage is fixed for 30 years at 4%, there’s always somewhere better to put your money:
The good, ol’ US stock market!
There’s almost* never been a 20 year period where the US stock market (as represented by the S&P500) hasn’t returned (earned) less than 9%.
*the lowest ever 20 year return still earned 5%, which beats your 4% mortgage ;)
And, investing in the entire US stock market is just as easy as popping money into a bank account: e.g. Vanguard or Fidelity.
Why save 4% on your mortgage when you can earn 9% in a low-cost index fund?
Just make sure you have the same long-term (10 year min.; pref. 20 years+) outlook, and the same investing strategy (e.g. regular monthly payments) on both.
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Putting your debt plan into action …
The interesting thing about consumer loans is that they either tend to be very cheap (e.g. your 4% mortgage or those subsidised 2% student loans) or very expensive (e.g. your 19% credit cards or that 11% auto loan).
So, that makes your strategy very easy:
- pay off your expensive loans,
- then invest (eg in a low-cost S&P500 Index fund),
- whilst you let your 30 year fixed-mortgage run its course.
If you always keep that benchmark of 9% (being the average 20 year return of the stock market) in mind, and remember that it will be close to 7% after tax:
- Pay off any debt with an interest rate of 7% or above, and
- Pay the monthly minimum on any debt with an interest rate less than 7%
- And, this is the most critical thing to remember: invest any extra penny that you can muster.
Oh, and if you bump into Dave Ramsey or one of his ilk, and they start to bang on and on about paying off all your debts, remember:
When interest rates are low (e.g. less than 7%), there’s always somewhere better to put your money.
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