The case for Paying Off Debt
We’ve all known the feeling of having debt. Whether it is student loans, car loans, mortgages or credit cards. Debt is a way of life practically everywhere around the world. It is such an irresistible concept after all. You get to have the gratification and utility now and worry about the cost later. Banks are perfectly willing and happy to oblige as long as they are paid an interest based on your credit risk profile. (By the way, have you ever thought why they call it a credit score and not credit risk score? It actually represents the risk of loaning you money, but they don’t want to make it obvious)
Here in America, the average mortgage loan at the moment charges an interest rate around 3%. The average car loan, 4% and the average student loan at 5.8%. Don’t even get me started on credit card interest rates. 16% is probably at the low end on that one. I’d feel better about being mugged.
The Normalization of Debt
Overall, our society has normalized debt. Why is debt so normal? If most of us have debt, who do we owe this money to? If you thought you owed this money to the bank, you’d be wrong. The bank doesn’t hold most of the debt they dish out. They spin it off and sell it to investors with surplus cash who then make money off of your interest payments. Credit Card and auto loans are sold off as Asset Backed Securities and Mortgages as Mortgage Backed Securities. If you’ve recently purchased a home with a mortgage loan, chances are that the US government purchased your mortgage. Essentially, Uncle Sam is who you’re indebted to because of the Federal Reserve’s unprecedented bond buying program over the last year to keep the economy afloat.
Student Loans are even worse because you cannot default on them. There are all kinds of programs to hit pause on the repayment and let the interest continue to build because there is no shortage of investors willing to forego short term gains for incremental long term returns. It is easy to see that there are two types of people in capitalism. People who are ‘in debt’, and people who ‘own debt’.
The big divide
If you are one of the few people who owns debt, good for you. But if you are one of the people who are in debt, unless you make a deliberate leap over the abyss, you will forever be stuck on the wrong side of the wealth divide. Capitalism lends itself very well to creating and widening this divide, especially in today’s age of psychological engineering.
That Lexus commercial that talks about how special a piece of metal whose sole purpose is to take you from point A to point B will make you feel, is the perfect example of this psychological engineering. If you fell for it, that special feeling will fade in a couple of months and all you actually did, was dig yourself into a deeper hole. Who REALLY made it, is the person that just loaned you the money for the car and will now help themselves to your cash every month, in interest payments.
Experts recommend your car should cost about 10% of your annual income. So everyone driving a $45,000 Lexus better be making $450,000 a year. Few actually do.
Removing the FLUFF
There is only one way to get to the other side of the increasing wealth divide. It is what I call, REMOVING THE FLUFF. Everything you see or hear has an awful lot of showcasing around it. The Lexus stripped off its badge and aura, is the same as a Prius (probably worse since the beamer costs more to maintain). A pair of Lululemon yoga pants serve the same purpose as Target yoga pants (even though as I write this, I can already hear Lulu fanatics in my head telling me how that is entirely untrue). Personally, I’d rather own Lululemon stock and be the beneficiary of the stupidity.
The truth is, there is a reason brands spend millions to create a perception about them. All indoctrination techniques so they could boost margins and sell at a premium. Is wearing Nike really getting you any closer to Tiger Woods’ golf game? Your ability to strip off this FLUFF will play a massive role in whether you are able to leap from ‘In Debt’ status to ‘Own Debt’ status.
Investing while in Debt
People often ask me –
‘Why should I pay off debt that is at a 4% interest rate when I could invest the same money and get 10%?‘
Why do you think the bank gave you a loan at 4% when they could have made 10% by investing that money too?
If you know of an investment that will pay 10% every year guaranteed, share it with me and I will give you a 3% cut from my own investment in it. The problem with the above statement is that you’re comparing a guaranteed interest rate with a speculative rate of return. If you’re looking for a guaranteed return interest rate, the best you can do right now is 1.6% which is what the US Treasury Bond yields.
You are required to pay a 4% interest rate on your debt. Whether the market is up or down. Whether you have a job or not. In sickness or in health.
Your returns from investing however, are impacted from all of the above. Market down? Lower returns. No job? Investments have to be liquidated for cash impacting returns. Sickness? Same thing to pay medical bills. In other words, debt payments are guaranteed. Investment returns are not.
As a simple rule of thumb, if you have debt, just contribute enough to get your company’s 401k match, budget for the rest and put all the leftovers (after saving enough for a small emergency fund) into debt repayment starting with the highest interest debt first.
The Leap Forward
Predictability with money comes at a price, but it is incredibly valuable in terms of peace of mind. This predictability is why the bank gave you the loan at 4% instead of investing in the market. Think like a bank. How can you make your financial situation more predictable while also generating decent returns?
Step 1 – Get out of debt
So remove the FLUFF and get conservative with your spending. Don’t worry about investing so long as you have any debt other than a mortgage (I say this because mortgage rates in most cases are very low AND homes are assets that appreciate in value over time, so they will help offset the interest bleed). Focus all your energy on planning and paying off all your debt. Student Loans, Credit Cards, Car Loans and anything else.
Welcome. You just jumped the abyss and you can now begin your journey to Debt Owner.
Step 2 – Begin investing
Start putting the same money you were paying towards debt, to work for you by investing it in cash flow producing assets like stocks/bonds/real estate.