[Disclaimer: Artist’s rendering of AJC … any resemblance to other bloggers living or dead is purely coincidental]
Have you noticed that I don’t have a category for debt on this blog?
[AJC: you can click on any of the keyword/categories in the orange header-banner above to see a list of blog posts focusing on that subject]
It’s not because we don’t talk about debt, as we clearly do …
…. it’s because, to me, creating or paying off debt is just the same as investing (after adjusting for tax: a dollar saved in interest, is the same as a dollar earned in interest or investment income, right?).
That’s why I was genuinely interested in finding out what was going through fellow-blogger Clever Dude’s mind when he loudly proclaimed:
We’re Free of Consumer Debt!!!!!!
As of today, we have paid off all $113,000 of our student loans, auto loans and credit card debt.
We are debt free!!!
My fellow blogger is right to be proud of his achievement … but, does that make it the right investment choice?
Check it out:
He paid off $113k … now, this is no small achievement, some people don’t even save that in their entire lifetime! Still I couldn’t resist asking Clever Dude for some details:
The rate on the student loans was 6.25%. The 2nd mortgage is 7.875%. First was 5.25%.
I chose to pay off the student loan because it was more manageable and I could get it off the books faster than the 2nd mortgage. Mathematically, the 2nd mortgage makes more sense until you factor in the tax deduction which brings them down to about equal.
I also wanted to know a little about his current net worth (after the mammoth debt-payoff feat) – nosey, aren’t I?! Anyhow, Clever Dude was happy to share:
Don’t mind the math as I rounded:
Cash: 17%
Investments: 37%
Home Equity: 6%
Autos: 17%
Personal Property: 12% (if I could sell it all right now)
Whole Life Insurance: 5% (yep, I got it, it’s expensive, but I’m not giving it up!)
So, Clever Dude has ‘invested’:
-> $113k in loans returning (by avoiding having to pay) around 6.25% after tax
-> 17% of his net worth in cash returning (I’m guessing here) 2%?
-> 6% of his net worth in his home returning some unknowable amount in future (potential) capital gains
-> 5% of his net worth in insurance ‘investments’ of dubious value after (often) exorbitant fees
-> 29% in (presumably) depreciating ‘assets’ such as autos and personal property
Now that he is debt-free, what will drive Clever Dude’s investment strategy from here on in? He says:
Investing and savings are next up in our planning. Honestly, we’ve spent so much time just thinking about debt, we haven’t spent much time on the future. Now is the time.
Now, I’m not here to pick holes in Clever Dude’s investment strategy as he had a strategy and moved mountains to achieve it – not to mention, that we know so little about Cleve Dude’s true financial situation that we are in no position to advise / criticize …
…. but, I do want to use this example to show why following a blind – and, in my mind totally arbitrary – investment goal such as “reducing debt” is not always the best idea:
Clever Dude has only 37% of his net worth in investments right now (OK, he is working on his Master’s Degree, so he has had other things on his mind) and has limited the bulk of his net worth’s returns to only 2% to 6% (or so) by almost-totally focusing on paying debt.
Why?
So, that he can start “investing and saving”!
Now, does that make sense to you?
There probably isn’t a universally right answer to this question – as you say we do not know enough about Clever Dude’s personal circumstances to say whether this was the right strategy for him. Only he can tell us that 0 and he is justifiably well satisfied with the results. That said, he is well ahead of most people in his age group. (I can say that it would be the wrong strategy for me – I need higher returns to meet my number before I set a world record for longevity.)
I do have two thoughts directed towards the future:
1. anyone who can deal with debt with the level of commitment that Clever Dude has managed would be well suited to managing the obligations which go with levergaed investments in real estate
2. if Clever Dude can keep his savings mentality focused to the same extent as he did paying off his debts (and not let the lifestyle spending take over), he should have no problems building up seed money for investments that will do better than cash in the bank.
Whether paying off debt will produce the best after-tax return is something that can only be known in the future. It is, however, almost certainly the lowest-risk option.
Although debt can boost total returns when things go well, it fails badly if your income declines at the same time that your assets lose value (something that has happened to a lot of people over the past couple of years). What had been a perfectly reasonable amount of debt suddenly became unsustainable when income fell sharply. At the same time, people who had a high net-worth suddenly found themselves with low (or even negative) net-worth, as the value of their assets collapsed. Unable to cover their debt service out of income, they’re forced to sell assets at the worst possible time. (Or, worse yet, if their assets are illiquid unable to sell them.)
If you have no debt, it’s easy to ride out a situation like this—just cut your expenses enough to bring them in line with your reduced income. If you have debt, though, you have no choice but to keep making the payments or else declare bankruptcy.
“It is, however, almost certainly the lowest-risk option”
@ Philip – Lowest-risk against what objective? Maintaining your current net-worth or achieving some future required net worth?
If the former, nobody would risk starting a business and innovation would virtually stop … financial progress implies carrying at least some measure of risk.
I propose that MOST financial progress requires SOME debt; but, that’s just a hypothesis 🙂
As Adrian has pointed out in may Past Posts. Paying off debt when the interest is so low, will most certainly reduce or make it tougher to achieve your number/date.You should just carry this debt(paying something on it each month) taking that extra money he used to pay down the debt and find a better (higher return Investment) to park it.This approach would help him move quicker to his number.
Just makes more sense ,if you have low interest debts,pay them off slower while at the same time, working on your goals for the future.This way,by the time those debts are cleared, you are already well on your way to reaching that magic number .
same situation as clever guy but shifting gears to divert some income away from debt repayment and into equities. would also like to start a net based sales company but motivation is a hurdle.
I posted a few months back. To remind you of my situation I graduated college 2008 from the University of Texas. worked at an oil and gas company in Houston named Flour Daniels. they had massive lay offs in 2009. I worked for a year and managed to save well over 50% of my pay. I reinvested it all into the stock market. I set up a regular investment account and a Roth IRA.
To date my Reg. Stock account is up 30%+ and my Roth IRA is up over 60%. and I still have another month to increase my yearly gains for it 🙂
I have had no prior experience with investing/trading. I played safer stocks/ETFs .. Bought on dips and sold when it would pop.
Oh and I also took out a loan from Citi bank.. who sent me a 10,000 loan offer in the mail with a 2% interest for the life of the loan. LOL.. I had to take it. I threw that into stocks also.
Any how my point is. If i had focused on paying off my $28,000 college debt I would have missed all of last year gains. I just made it a goal to beat my debt interest. and I did!
Currently I have enough money to pay off all my debt. but of course i’m not going to do it. I took out 2K from my portfolio to invest in an online woman’s clothing site. We have great style at affordable prices. we are not making huge profits.. but we are selling and that is encouraging. I know I have to get a job soon to support my venture. But I hate working for the man. I want to be the man.. haha. I plan to get a job in a few months when the site becomes more hands free.
I’m 25. My goal is be a millionaire by 2018. I gave myself 10 years after college to do it. 😀
Thank you Adrian. Reading your site motivates me more.
@ Eric – A great example of the benefits of NOT paying down debt (cheap debt, that is) 🙂
Auto loans these days are a bit expensive, this is also a side-effect of the economic recession.;.