Why You Need to Get Out of Debt… And When You Should Stay in Debt
Most people understand that being in debt is generally a bad idea. Yet over 75% of U.S. families have some sort of debt. What does all this debt cost us? Is it always bad to carry debt?
Debt is defined as money that was borrowed and is to be repaid on certain terms. The terms usually include a specific time frame regarding when the full debt will be repaid, regular payments on the debt, and interest on the principal balance. People take on debt for a variety of reasons. But all those different reasons usually boil down to one thing — not having enough cash.
Generally, going into debt is not a good idea. Though ideally you would never go into debt, our modern society often requires a person to carry some form of debt throughout their lifetime. The US Federal Reserve found that Americans with debt have an average of over $120,000 of it!
Yet, plenty of people have debt and lead fiscally responsible lives. So if the majority of people carry debt, what enables some to succeed while others struggle to stay afloat?
High Interest Debt
Not all debt is bad debt. The one type of debt you want to avoid is what I call high interest debt. High interest debt is any debt that has an annual interest rate over 10%. Why 10%? Well let’s think about this. If you put $100 towards a debt with a 10% annual interest rate, your $100 has essentially saved you from paying $10 in interest. The stock market typically returns about 9% per year. If we put that same $100 into investing, you would have made $9 at the end of the year. The choice is between saving $10 or earning $9. It’s pretty clear where you should put your money. A 10% interest rate also happens to be right about where personal loan interest rates stand which you generally shouldn’t be taking (and it’s a nice round number).
If we look at credit card debt, the most common source of high interest debt, the US Federal Reserve found that 44% of families had some sort of credit card balance as of 2016.
For families that have credit card debt, the average debt is just under $6,000. The average interest rate for a credit card in the US is just over 13% as of February 2018. Each time you pay down debt, you’re essentially getting a return equal to the interest rate on the debt. As we saw above, it’s obviously best to pay off your high interest debts before making investments.
But how much better is it?
Say you’re just like the average American family with $6,000 in credit card debt. If you were to only make the minimum payments on your card, often the higher of 2% of the balance or $25, it would take you over 20 years to pay off that card. And in that time, you would pay $6173 in interest. You end up doubling the amount you have to pay!
But that doesn’t give you the full picture of the costs. The money you paid towards your credit card is money that could have been invested instead. Let’s say our friend Tommy has a $6,000 balance on her card and she decides to pay just the minimum required. Her card carries an interest rate of 15%. She knows that investing is important for her future so she decides to start investing and is able to get the average 9% return per year. Each month she puts $200 total towards her minimum credit card payment and investments.
With this setup, it ends up taking her 25 years to pay off her $6,000 debt. She ends up with a nest egg of just over $135,000 after 25 years.
Let’s take the same scenario and instead of making minimum payments, Tommy puts all of the $200 towards her card payments before starting to invest. After all, she’s getting a better return by doing so, so she should have more money in the long run.
This turns out to give her a lot more money. By paying off her card first, she’s able to pay off her $6,000 balance in just over 4 years. Not only that, her investments grow to over $149,000 in the same 25 year time period. By prioritizing her credit card first, she ends up with $14,000 more!
It’s now obvious that we should prioritize paying down high interest debt first. But we can take it a step further and avoid having this debt in the first place. Credit card debt is usually caused by impulsive spending on things that we can’t afford. If you don’t have the cash to make the purchase outright, then you shouldn’t be putting it on a credit card. You should always be paying off your credit card’s full statement balance at the end of the month.
Let’s look at one more scenario with Tommy and see what would happen if she didn’t have any credit card payments at all. She instead took the $200 per month and invested it from the beginning for 25 years. With this scenario, she ends up having over $200,000. A $6,000 debt actually results in a $75,000 loss in net worth over 25 years! As you can see, not having those debt payments really helps to build her nest egg over the years thanks to compounding interest.
Make it a priority to pay off your high interest debt. Paying off those debts is likely going to get you the biggest bang for your buck.
Low Interest Debt
We can see that high interest debt should be avoided at all costs (puns!). But credit card debt only makes up about 5% of all debt. What about the other 95% of debt that Americans typically have? It turns out mortgage, auto, and student loans cover nearly all other debt the typical American has. If you can, it’s better to avoid debt altogether but the majority of people will end up with one or all of the three debts above. So how should you handle these debts?
For debts with low interest, keep them as long as possible.
That’s right. You want to stay in debt. Let me explain.
Remember above when we were talking about the reasons why you want to pay off your high interest debt before investing? Well that same rationale is why you shouldn’t pay off your low interest debt. If you have a 4% interest rate on your debt, putting $100 towards that debt saves you $4 in interest. But if you invest that same $100 in the stock market, you can expect a $9 return. Save $4 or earn $9. I know what I prefer.
Now I know this isn’t going to work for everyone. Making the conscious decision to keep your debt instead of paying it off requires a shift in mindset from “wondering where your money went” to “deciding where your money will go”. If you struggle with managing your finances, start by making a budget. You could also check out other debt reduction strategies like the Debt Snowball coined by Dave Ramsey.
But if you’re already practicing conscious spending, then you’re going to love what I’m going to show you.
Let’s say Tommy was fiscally responsible and avoided high interest debt. She is just starting her career and has student loans, an auto loan, and is getting a mortgage for her first house. Her loan details are below.
For the purposes of this example, we’ll say all three of her loans have a 4% interest rate. In reality, they’ll likely differ slightly but will probably be between 3–5%.
Tommy made it a personal goal to be debt free. She prioritized paying off her debts, which allowed her to set aside $1,500 towards her monthly payments. She decides to tackle her auto loan first since it is the smallest debt. She makes minimum payments on her mortgage and student loans and puts the rest to paying down her auto loan. After 3 years and 4 months, her auto loan is paid off. She then applies the amount she was paying towards her auto loan to her student loans. Doing so allows her to pay off her student loans in 5 years and 1 month. She finally takes all $1,500 and puts it into her mortgage. Tommy’s mortgage is paid off in 14 years and 3 months.
After 14 years, Tommy is proud of herself for becoming completely debt free. She turns to investing and puts $1,500 towards her retirement accounts. She gets a 9% return and invests for 16 years after becoming debt-free. Tommy is able to retire with $700,000.
Now we could stop there and there’s no doubt that Tommy made some good financial moves. But let’s consider what would happen if Tommy made the minimum payments.
With the same loans and same amount of money, at the beginning of Tommy’s career she would have just over $300 leftover after paying the minimums on her loans. Tommy invests this extra $300, getting the average 9% return. After Tommy’s 5 year auto loan is paid off, she puts those payments towards investing and is now investing almost $600 per month. She does the same thing when her student loans are paid off which gives her almost $800 per month to invest. She continues to pay the minimum on her mortgage and invest the rest.
After 30 years, instead of $700,000 to retire on, Tommy has over $1,000,000. By holding on to her low interest debts a little longer, she is able to retire with over 40% more!
I’ve always known to stay away from high interest debt. The combination of high interest rates and low minimum payments results in so much being paid in interest it’s ridiculous. The same isn’t true for low interest debt. You still shouldn’t take on debt if you can help it. But for life’s big ticket items, sometime it can’t be helped. When you do have to take on low interest debts, it can pay off in a big way to make minimum payments and use your money for other things.
If you want to get rid of your debt to simplify your finances, it’s not a bad idea to pay it all off. In the example above, if Tommy had paid off just her student and auto loans early, continued to pay the minimum on her mortgage, and invest the rest, she would have just under $970,000. She essentially would have traded $30,000 to live debt free (other than her mortgage) 5 years early.
Like most people, I assumed all debt was bad debt. That’s why my wife and I made the “mistake” of paying off our auto and student loans early. As of this writing, we’re living debt-free. But we’re about to purchase our first home and, knowing what we know now, we’re not going to make more than the minimum payment. There are better places to put our money.