Flexo (at Consumerism Commentary) wrote an interesting piece on debt reduction; in promoting his Debt Avalanche over the Dave Ramsey’s Debt Snowball, Flexo said:
One major problem I have with the snowball approach is that your largest balance may be significantly more expensive than your smallest balance. Today it is not difficult to find a default interest rate on a credit card north of 30%. There is no way in good conscience I could recommend holding off on eliminating a debt this expensive in favor of paying off a small balance with a 7.9% interest rate. The same goes for payday loans, whose fees can border on usurious if interpreted as interest rates.
I agree totally, but then reminded Flexo that there is a third method – one that I humbly invented – called The Cash Cascade which encourages you to consider what you will do AFTER you have paid off your debt … and, perhaps do some of that instead!
Flexo sent me an e-mail and asked me to to “describe at least a summary of [my] method in the comment”, which I did as follows:
We are all familiar with the concept of ‘good debt’ and ‘bad debt’, but most don’t realize that this is only a way of avoiding getting INTO (bad) debt … once we have acquired the debt, then we need to start thinking of debt simply as ‘cheap debt’ or ‘expensive debt’. The Debt Avalanche is clearly ideally suited to attacking the ‘expensive debt’ first.
However, there is another part to this: our ultimate financial goal is usually not to become ‘debt free’ (although, that may be a tactic that some would choose … not me!), rather to achieve financial independence, or wealth, or [insert your life-supporting goal, here], and often a part of the strategy will be to acquire SOME debt in order to get there while you are still young enough to enjoy life e.g. you might decide to take out a mortgage on an investment property, or a margin loan on stocks, or a small business start-up loan, etc.
Clearly, it would make NO sense to delay investing just so that you can pay off relatively cheap debt (e.g. student loan, mortgage, etc.) i.e. just to take out more expensive debt later (e.g. the small business loan) … instead, leave the cheaper loan in place and “pay off’ the more expensive loan by not taking it out in the first place!
Once you think about debt and investment as ‘cheap’ v ‘expensive’, it becomes easier to apply the principles of the Debt Avalanche to both debts AND investments 🙂
Not sure if my thought process was very clear, but it certainly stimulated an unbelievably clear comment, from another reader – Kitty – who said:
I would like to second 7million7years in that keeping fixed low interest debt around instead of repaying could be a valid investment strategy. One thing to keep in mind always is the possibility of future inflation and/or higher interest rates – a reasonable expectation nowadays.
If your debt is at 4.5% now, it may seem like higher than you can get on a normal CD. But what about 5 years from now? During the early 80s where you could get double digit returns on normal bank CDs people who had 30-year fixed mortgages at 9% were feeling very lucky… Long term fixed low interest debt is as much a hedge against inflation as buying commodities or TIPs. In fact I have a couple of multi-millionaire friends who took a mortgage on their vacation home when they could’ve paid for it in cash.
I don’t know if I would finance my vacation home – unless, I had something MUCH better to do with the money – but: “long term fixed low interest debt is as much a hedge against inflation as buying commodities or TIPs” …
… using debt as a Making Money 301 tool? Brilliant, Kitty!!
I only wish that I had thought of it, first 🙂
Yep. I’ve always struggled to understand why people who are still accumulating wealth would want to pay off debt that is not only cheap in absolute terms but often costs less than the expected rate of return on available investments. It just seems like a no-brainer to me.
On the inflation hedge, I would go further and argue that if the demographics etc stack up a leveraged investment in real estate is a better investment in inflationary times than TIPs – you get nominal appreciation on the property (which may be more or less than the rate of inflation) as well as the real reduction in the value of the debt. In the inflationary 1970s this was a good way to make money.
Now if only I could get long term fixed interest rates in Hong Kong (where the one month floating rate on a mortgage is currently less than 1%)…..
I totally agree with this post. If you are working your way along Money Making 201, your goal is to build wealth and you’ll have to leverage yourself in some way, either through ‘sweat’ equity in building a business or businesses, or you HAVE to look at how to get far, far greater returns than what you would get by paying off that cheap debt!
Incidentally, as I read this post, I also got an email from Sallie Mae stating: “Due to your diligent and timely payment on your student loan account, we are proudly dropping your interest rate by 1 percentage point”.
That student loan was already locked-in at 2.8%. Now, a fixed 1.8% rate on the loan is another gift I’ve just received to get to my NUMBER FASTER! 😉
@ Scott – this is an extreme – but valid – example: why pay off a 1.8% student loan when you could just let your repayments sit in the bank and earn you 2.9%?
Similarly, why pay off a 5.9% home loan when you can earn 8.5%+ in the stock market (e.g. mutual funds)?
Or, why pay off an 11.9% car loan when you can start a business with the money that you saved (by NOT making the extra car loan payments) and earn 50%+
… of course, if you can’t / don’t intend to do any of these alternatives, then by all means: pay off the loan/s … at least then, when you retire in 20 to 40 years on the equivalent of $15k to $30k today you won’t have any debt 😉
LoL, exactly. I thought I was lucky before by having the loans locked in at such a low rate to begin with. Inflation alone was already eating away at the loan, but now with an interest rate a point lower, inflation is really eating away at it.
I just logged onto my account and unfortunately, they didn’t give me a lower payment for some reason. They are still keeping my payment the same but applying more of the payment to principle via the lower rate. They put a statement in there that the loan would be paid off sooner due to the drop.
Oh well i’ll take all the gifts I can get!
Wonderful Post here.
I have something to share, not related to this topic, but I found it interesting and hoped it might be inspirational to some others who visit here.
I received this in an email the other day.
Quote of the Day
Soichiro Honda, Founder, Honda Corporation
“To me success can only be achieved through repeated failure and introspection. In fact, success represents 1 percent of your work that results from the 99 percent that is called failure.”
@ Steve – Thanks for sharing.
Borrowing in a deflationary / recessionary market is not such a wise idea.
@ Mike – I agree; but, I’m also suggesting that paying down low-interest loans rather than keeping a war-chest to buy ‘recessionary discounted’ income-producing investments may not be such a good idea either 😉
I guess I don’t understand why it’s not a good idea to borrow in a deflationary(actually I think this is more of a disinflationary time than deflationary)recession market? When would you be able to find cheaper prices on anything?
As the old saying goes, buy when there’s blood in the streets. Get greedy when everyone is fearful. Do opposite of the herd.
From everything i’ve read and studied now about finance, more millionaires are made from a recession than any other times in history because of cheap real estate, cheap businesses, cheap stocks, etc.. etc…
@ Scott – if inflation makes your fixed rate loan cheaper in the future, then deflation must do the opposite!
However, deflation tends to be a shorter term effect, so I don’t really ‘buy’ the deflationary argument IF you intend to buy/hold for the long-term and can produce cash from your investment from the get-go … at least, that’s my opinion. Mike?
Yeah I definitely understand that effect on my student loan, but I’m more interested in deflation or even disinflation’s effect on my war chest and the return I can get by taking advantage of the current market FAR more than I’m concerned about it’s effect on my low-fixed, locked-in student loan.
The only reason I brought up my student loan is because like you said in your post, it makes more sense to leave it be and focus on far greater returns than what the interest rate on the loan is. But I had to mention that in addition to my strategy to just pay the minimum on that loan so that I can build up more war chest money, I got rewarded with a 1% interest rate drop on an already ridiculously low interest rate on the student loan. 😉
Best of both worlds occurring at the same time, gotta love that. 😉
Great site very helpful information
Another great post Adrian.
When I think about DEBT it is always in the context of what it is supporting. So DEBT on a credit card is completely different in my mind to DEBT on a business.
As investors a key indicator of performance is RETURN on EQUITY and the higher the better. If I want to achieve higher returns it usually requires more investment than I have personally which is why we turn to the use of debt( leverage) to achieve the higher investments.
So IF I’ve used DEBT to acquire more investments then the returns on those investments should pay off the interest on the debt and leave me with a great NET return on investment. PROVIDED the returns are in excess of the interest everything should be sweet.
Interest is a fixed amount and payable in cash. Returns are fluid and may not always be in cash.
So in many circumstances, paying off the debt can lower your opportunity to invest that money into investments which bring in returns well in excess of the interest on the debt.
@ Andee – Yep! The counter-argument is one that you put forward in your Financial Fence game, that:
a) there are commonly-accepted ratios for business that tell you when you have too much debt, and
b) your game puts forward some ratios for private investors to ensure that they, too, do not acquire TOO MUCH DEBT.
My question is: if “paying off the debt can lower your opportunity to invest that money into investments which bring in returns well in excess of the interest on the debt” …
… why isn’t MORE debt of this type better? Why do we place (and, measure via these ratios) restrictions on the amount of debt that we take on??!
The limitations we put on debt are where there is NO RETURN from the capital which is supported by that debt. Also using a DEBT / EQUITY measure gives each individual the opportuity to have a risk profile which suits their appetite for risk.
SHAPE is the key here which is governed by the RETURN on EQUITY which takes into account BOTH the interest costs and the investment profits.
Bottom line for me is that DEBT should be paid back when the capital it is supporting can not get a return which is at least 3 times the cost of the debt.