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?
I agree with what you are saying, but what happens when you buy that rental property and suddenly you can’t find tenants? Or a military base closes nearby? Or your tenants trash the house and skip town?
You can get stuck making dual mortgage payments and it can take you down forcing bankruptcy! Is it likely? Probably not. Has it happened? Tons of times.
Your scenario completely ignores the cost of risk. Mispricing risk is what got our whole financial system into this mess, you have to account for it or it will eventually bite you in the ass.
Would I do your scenario four? Sure. But be realistic about the risk you take on. Paying off that student loan is a 100% risk free return. Buying a second property is not.
Good article, and I don’t disagree with anything you said here. Good point about cheap vs. expensive debt as opposed to good vs. bad debt.
In some of my articles, I also pointed out this exact concept. You’re using student loan at 2.5% to make a point, but not paying off a 6.5% mortgage may be the right move for some people as well.
ohh I am loving that cartoon, hilarious
Yes I agree, but I just say– there is more than one way to become rich
Some people pay off debt and invest the rest– others pay the miniumum and start a busines or invest in short term real estate then pay it all in one sum when the pfits come in
I did a little of both, a side business can work wonders! One is just slower than the other
@ Allen – You can be ‘risk free’ and Just Over Broke, too. Please reread the title to this blog 😉
If your objective is to work until you’re 65 and ‘retire’ on the equivalent of your current salary (probably, a lot less) then, I agree, you should focus on (a) saving and (b) reducing risk.
But, if your intention’s even a little more ‘grand’, then ‘investing’ at 2.5% (after tax) to 6.5% (before tax benefits) is hardly going to cut the mustard isn’t it?
I agree with your point, Adrian. I’m not saying people shouldn’t take risks.
I’m just saying you can’t look at ‘option A’ as being better than ‘option B’ and completely ignore than Option B has risk. That risk has a price, a discount value that reduces the benefit of selecting it.
If you don’t have a good risk mitigation plan, and don’t understand the impact to your investment when those risks come to pass, you MIGHT end up in worse shape.
Again, my point is that you should do the real estate deal as presented above, but don’t leave the cost of risk out of the equation.
@Allen/Adrian – All good comments, thanks! Since this was really a post about which debt to pay first, I did gloss over the risk/reward analysis thing, but I think it is implicit in this statement:
“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?”
@ Pinyo – Yep; I obviously chose the ‘easy’ example of the 2.5% student loan, but I totally agree that there are PLENTY of low-risk investments that deliver more than a 6.5% mortgage (esp. if this can also be discounted for tax benefits).
Thanks again for the original inspiration via your post on Debt Snowballs v Avalanches v Bazookas 🙂
I was reading Scott’s post yesterday about how him and his wife are keeping their student loan as a norm instead of snowballing it. And then I read this post and you explained why you recommended him to keep in the norm. I think it was kismet to see these two posts! lol.
I really do like this cheap debt vs. expensive debt. I think I may just try that out. Let me see what I can tweak in my spreadsheet this weekend. Thanks! I needed that wake up inspiration. 🙂
@ Money Funk – Let us know what your Magic Spreadsheet comes up with?! 🙂
Using the Debt Snowball Calculator
It will take me 32 months to pay off $48,000 of debt (this does not include the $32,000 in student loans since they are locked at a rate of 3.25%)
If I pay by Ramsey’s snowball method:
I will pay $1,583 more in interest for a total of $8649
Total Interest Paid $7066
Of course, I need to assume that I will find other income streams to make this debt repayment go by faster. Thereby, saving a substantial amount of interest if I Avalanche. 😉
posted about it, here
@ Money Funk – It’s ironic that paying the debts off faster REDUCES the relative interest savings advantage of the Avalanche over the Snowball …
… but, this is a great illustration of the true cost of Ramsey’s fairy-floss method – no substance 😉 – of paying off debts.
Sorry, don’t mean to post again. But, I really had to numerically figure out how much the senerio could save me.
My previous post showed the savings in Snowballing and Avalanching (part 1).
Now this post explores how much I could save if I looked at it as Cheap Debt/Expensive Debt. The saving could be grand!(part 2) Its the nerd in me that I had to figure the outcome.
Thank you for the insight. Nice post.
@ Money Funk – Post away! I’ve read your (now two) post/s on the subject and I think they are way cool 🙂
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David Ramsey was on TV today…. I guess he has a regular thing, I just never knew it. He basically said this “If you are in debt, you should never see the inside of a restaurant unless you work there.”
My dad is just as bad. He got $5000 from an inheritances this week, from when my grandfather died. My mom god $120k. My dad cashed the check and took $4000 of the cash and paid down his car, because he just could not live with his 8.2% interest rate. Took the rest and made a payment to his credit card. At least with the credit card he can get it back if he needs to but on the car there is no way. It does reduce his monthly payment by over $150.
My mom is thinking of calling up all her credit cards, and trying to settle with them because she is behind on it. She also is thinking of putting 20k on to pay off her cars. Also when she got the money she kicked out the crappy tenant she had in her rental house and is going to make it her winter home, there goes $1200 of monthly passive income.
I keep trying to tell her not to do this but they don’t listen. My brother sold his Lexus Ls430 that he paid cash for during the good times. He put 10k on his Amex and 10k on his second mortgage, the next month both of them closed his accounts because he no longer had a job and was increasing debt with other accounts. He cashed out his E-Trade account for under 15k, he put 40k in it 2 years ago, that is how he is living now.
For me I was so glad that I was in debt when this crisis came about. I simply decided to stop paying most of my bank debts. I still pay the credit union (because they are a non profit and get no government money), my family members, my bills and of course my business partner gets his cut of profits each week. But I was able to stop paying all the rest and wait a while until they got all their bailout money, and then renegotiate with them, then pay them a lesser amount. So far I have saved over $120k, and I have over 100k more still pending…..(60k is debt from a former employee who embezzled from me.) I think it will be over $200k of debt gone, while the business and personal assets remain. My business is doing good also and I think that this year my net worth will go up by over 250k.
@ Jason – Thanks for sharing; I don’t see a problem with your dad ‘saving’ 8.5% interest PROVIDED that he uses that $150/mth for investing or at least paying down other higher interest debt rather than spending it.
Your Mom should pay down all of her debt with the $120k and use the rest PLUS the monthly debt repayments that she has ‘saved’ to prepare for (or improve) her retirement: perhaps TWO rentals with ‘crappy tenants’? 😛
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