Good Debt Vs. Bad Debt - Or Why I'm Not An Anti-Debt Proselytizer
Last month I opened up Robbins’ Nestegg by talking aboutdebt – my situation is little changed when I round up, except that I’ve paid more than $200 down on my car payment, which I identified as my primary debt goal moving forward. I hope to eliminate my approximately $7,900 car loan in 2019 – and that’s not another specious New Year’s resolution, that’s a plan.
A lot of the financial independence, retire early movement is geared towards rapid debt elimination. In fact, much of the personal finance space – especially the for-hire personal finance gurus and coaches – are debt obsessed. Some will even advise people to eliminate all their debt before they start seriously saving and investing.
I’m not one of those people. Yes, you should be aware of your debts, how much interest you’re paying on them, how long it will take you to pay them off and the overall cost of holding that debt over however long you estimate it will take you to pay them off. That’s just good planning. In fact, it’s such a good idea that in one of my next posts (probably next week), I’ll conduct that exercise on myself to give you an idea of what it looks like and how the information from debt analysis can be used in a financial plan.
But that’s a slight digression – I don’t think that paying down all your debt right away or as soon as possible is the best possible strategy for building wealth and moving towards financial independence. In fact, being too debt obsessed can cost you in the long run and create a longer path to financial independence and, if it’s your goal, retirement - especially if you’re a young, low-to-upper-middle income professional with a mortgage and/or student loan debt.
That’s because most of the mortgage and student loan debt incurred over the past 15 years has been issued at interest rates well below the average annualized return from equity markets.
Let me back up here. When you earn your income, those nice paychecks and direct deposits and/or dividend and interest payments, you have choices on how to use that income. Some will obviously go to pay hard costs and liabilities like utility bills and food and transportation, some will pay minimum payments to service your debt, some will be lost to taxes, some will go into your lifestyle slush fund that enables you to enjoy a latte or a beer every once in a while, and the remaining excess is yours to save and invest, spend or direct towards debt.
Whatever you choose to do with your excess money, there’s an opportunity cost to doing that thing. For example, if I had $1,000 in excess income and I chose to spend that money on concert tickets, drinks and a new set of noise cancelling headphones, I would be paying an opportunity cost of whatever I could have reduced by debt service payments by, or whatever investment return I could have earned with that money. Similarly, by saving and investing the money, I would incur an opportunity cost of either my minimum payments on debt, or the good time I would have enjoyed with the concerts, drinks and headphones.
If I choose to pay down debts with my excess income, I’m accepting an opportunity cost of the good times and whatever investment returns I could have earned with my money.
The right decision on what to do with your excess income should include more than a simple comparison of financial opportunity costs, but it’s a good place to start. So let’s look at what can happen if you’re too debt obsessed.
I don’t have the figures right in front of me, but our student loan debt accrues interest at a rate of approximately 4% each year. Our mortgage carries a similar interest rate (I’ll eventually have to devote a whole post to whether I think one should pay of one’s mortgage ASAP or not, because it depends heavily on the terms of the particular mortgage). For simplicity’s sake, not paying an additional $1,000 on these debts would result in an extra $40 in interest payments each year.
Here’s where a lot of analysis ends – why not save yourself the $40 a year? Over a 30-year mortgage, the compound effects of $40 in savings now can snowball into significant savings, right? If you’re sensitive to debt and owing money, it really does sound like the best way to achieve financial independence.
But we’re neglecting the opportunity cost of not investing – especially the cost of not investing while one is young.
The Cost of Not Investing
Over the last 30 years, the total return of the S&P 500 index, a broad-based representative collection of U.S. stocks, including reinvestment of all dividends, was 7.738 percent when adjusted for inflation, according to this handy calculator from “Don’t Quit Your Day Job.” Over the past 50 years, that number falls to 5.784 percent, largely due a market crash and a prolonged period of “stagflation” experienced in the 1970s.
Yet even the lower number greatly exceeds the 4% in interest we’re paying on our debts. In the 30-year scenario, I would be sacrificing an additional 3.738 percent in annual returns compounded for 30 years if I chose to pay down student loans and mortgages before investing in equities. I don’t need a calculator to tell you that’s going to be a lot of money for a household like mine.
I call debts that accrue interest at a higher rate than a vanilla, inflation-adjusted reading of equity returns “bad debt” and usually advocate for paying them down ASAP. Debts that accrue interest at a lower rate than the returns from the S&P 500 over time are deemed “good debt” and can wait as long as I damn well feel like waiting to pay them off.
Because the potential gains I get from putting more money in the equity markets well exceed the potential costs of delaying the elimination of my debt. I would be sacrificing a portion – likely a significant portion – of my potential future wealth to make myself feel a little bit better about my debt situation in the present.
Every day a young person delays participation - and delays maximizing their participation - in equity markets represents a lost opportunity to build wealth.
Now credit cards that charge 10-25 percent annual interest, or personal installment loans that may carry interest rates of more than 7 percent, or any other high-interest-rate debts deserve a higher level of attention and urgency. Those are the ones that you want to put away an extra $200 a week towards - or more if possible.
While I do acknowledge that there are those among us who are so averse or sensitive to debt that they absolutely must pay down their good debt as soon as possible in order to enjoy their lives, I think a lot of the anti-debt sentiment of people like Dave Ramsey and the financial independence blogosphere comes from instant gratification bias.
Rather than be patient and pay down the debt at a reasonable rate while maximizing investments and wealth, it’s conceptually easier to think that all debt is bad and to emphasize getting rid of it like cockroaches from one’s kitchen.
But it doesn’t make sense, and it’s terrible advice for most people. Most of you reading this should think about saving and investing your money first, rather than rushing to pay down your low interest debt. Instead of paying down your student loans that may charge you 4 percent or less each year in interest, go out and buy a low-cost, passively managed ETF or mutual fund of U.S., developed market or emerging market stocks. Even better, do it through a no-commission, no-transaction-fee platform like those run by Schwab, Fidelity, TD Ameritrade, Vanguard and others.
The odds strongly suggest that you'll be wealthier in the long-run for doing so.