Let’s face it, if your whole goal in life is to simply get rid of your debt you are probably reading the wrong blog ….
… but, I am working on the assumption that you feel that paying off debt will help you get rich(er) quick(er).
Well, most people that I talk to say: “I will become debt free then I will have all that money spare to start investing … stress-free because I’ll have no debt to worry about”.
Stress free, until I point out that paying off debt early to start saving up to invest later is the long road to nowhere. You see, they will simply start investing too little, too late to make a dent in their true retirement needs … assuming that living on an ashram, eating rice-cakes three times a day isn’t their ideal future 🙂
When I point this out, they say: “Oh no, I’ll be accelerating my investment plans because I’ll be borrowing to buy an investment property … you see, I’ll have paid off all of that BAD DEBT (on my car, my TV, my house) and be ready to put all of those monthly payments into a big, fat GOOD DEBT loan on an investment property”.
Then they point me to all the methods that might be used to quickly and efficiently pay down all of this ‘bad debt’ – conveniently and cleverly collated in this blog post by my good blogging friend, Pinyo, over at Moolanomey – and:
I’ve got ’em right where I want ’em …
You see, the concept of ‘good debt’ and ‘bad debt’ only applies when you are deciding whether to take on debt or not.
Let’s take the following two examples:
You want to buy a car on finance = BAD DEBT
You want to buy a ‘positive cashflow’ investment property by borrowing 80% of the purchase price from the bank = GOOD DEBT
Still with me? Good.
Now, here’s the twist: once you have acquired the debt, there is no more ‘good debt’ / ‘bad debt’ anymore … there’s only EXPENSIVE DEBT and CHEAP DEBT.
I don’t think that this is something that you’ve ever seen anywhere else (at least, I certainly haven’t!), so let’s take a simple example to explain:
You used to have a $25,000 student loan (at 2.5% fixed interest) and a $5,000 car loan (at 11.5%) … and, you cleverly and diligently worked at paying off the car loan at the rate of $150 a month (your minimum payment was $50 a month, so you paid it off pretty quick … good for you!), while maintaining your minimum payment of $25 a month on the student loan.
Now that the car is paid off, you are naturally planning to apply that whole $175 a month to the student loan and have it paid off in only a few years (yay!) … is this the right thing to do?
Well, let’s apply the cheap debt / expensive debt test to the alternatives available to us:
1. Pay down the student loan (save 2.5% interest), or
2. Spend the extra $150 a month on all the stuff we’ve been going without (an effective 0% earned or 100% ‘interest’ expense on the money spent, depending on how you want to look at it), or
3. Stick the money in a CD (earn 1.9% interest).
Clearly paying down the student loan is the best ‘bang for buck’ that we can get, here, and spending the money is the worst.
But, what if we add a fourth option:
4. Use that $150 a month to save up for a deposit, then apply for an 80% loan to buy an investment property (pay 6.5% interest).
Using my ‘cheap debt / expensive debt’ rule, you would immediately work on reducing your most expensive debt, which is the 6.5% mortgage loan … and, the best way to reduce it is by keeping $25k of it in the cheaper (2.5%) student loan.
However, the ‘Ramseyphiles’ would pay off the student loan (BAD DEBT), then save up the entire $175 ($150 + $25) for the deposit on the investment property (GOOD DEBT), and spend a lot more in interest for the privilege.
Now, do you see the sense in doing this?
Well, I can’t!
Why pay down a $25,000 loan at 2.5% just so that you can replace it with another $25,000 loan (plus ‘another loan’ for the remainder of the amount that you will need to buy the investment property) at, say 6.5% or 8.5% or whatever the interest rates will be a few years down the track.
Not, only do you pay more in interest, but you delay the purchase of the ‘cashflow positive’ property which means that you are putting less cash INTO your pocket and missing out on all of that extra appreciation on the property, not for the benefit of being debt free (because you will have a nice, fat mortgage on the property), but for the very minor advantage of only have one larger loan to pay rather than two smaller ones (student loan, plus $25k smaller mortgage).
If you don’t think the property is going to make you money, why buy one at all … and, if you do think it will make you money, why delay?
When thinking about finance, it’s much better to shift your focus from the means (paying off debt) to the ends (having enough passive income to fund your ideal life) …
If you’re interested in understanding more about how this works, read Pinyo’s post to get the basic Debt Snowball mechanics set in your head (he has a nice diagram), then read the Cash Cascade where I explain in video and words how to make this work – even better, in my most humble of opinions – for you 🙂
But, if your sole goal really is to become debt free, why not consider doing it the easy way as the cartoon above, suggests?