In my last column, we discussed Financial Fallacy No. 1: The safest place to keep your money is in a savings account. This week we are going to look at Financial Fallacy No. 2, which is: Pay off all your debt as soon as you can.
It seems that just about every place you turn people are suggesting that you pay off all of your debts as soon as possible and then stay out of debt. Some even expand this concept to include paying off your home mortgage. In fact, the current trend today is to try to pay off your home mortgage in 10-15 years instead of 30 years.
Now, before we go any further, let me stop and emphatically state that I am not suggesting that you go out and charge up a bunch of things you cannot afford on your credit cards. That is the fastest way I know to financial disaster.
The problem comes, however, when people try to accelerate certain debt on big items like their cars and home. In these cases, what they usually are doing is using the money they should be investing to build their retirement plan, or their children’s college education funds. The result is that they finally get their debts paid off, but they do not have enough time left to invest enough to accomplish their long-term financial goals.
Therefore, the real question we must answer is, “Should you extend your debt, or pay it off?”
The financially trained person realizes that there is actually something called “Good Debt,” as well as “Bad Debt.” Some debt should be paid off as soon as possible, while other debt should be extended as long as possible.
Let me give you a formula to help you determine when your debt is Good Debt or Bad Debt.
Good Debt is when the debt actually makes you a profit. Bad Debt is when it costs you money.
My Good Debt/Bad Debt Formula states:
“Debt is justified anytime the net cost of the debt (the interest you pay) is less than then the net income earned through investments made with the money borrowed, plus any benefits of inflation.”
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Let me take an example of a typical home mortgage decision to show you how this formula works.
Today, you can get a 30-year fixed rate home loan for about 4 percent. If you think about this, that 4 percent interest cost is the only disadvantage of financing.
Let us also assume that you have some money set aside and do not know how much of it to use for the down payment. Most people would recommend that you pay as much down as you can afford, and finance the rest.
Another version of this same issue is whether to take a 30-year loan, or make high payments so can get your loan paid off in 10-15 years. Both examples are really asking the same question: “Does it make sense to put your excess money into your home mortgage to reduce your total interest costs on your loan?”
My Good Debt/Bad Debt Formula will give you the answer.
To use the formula, first take the interest, which in this example is 4 percent. Because it is a home loan, your interest is tax deductible. This means if the last dollars you earned are taxed at the 28 percent tax bracket, then Uncle Sam will refund 28 percent of the 4 percent in interest you paid, or the equivalent 1.12 percent. Therefore, your net cost of interest is really only 2.88 percent (4 minus 1.12).
Now hypothetically let us say you invested the extra money you did not use on the down payment, or paid in higher house payments, into a 30-year “AAA” rated Municipal Bond to match your 30-year home mortgage term. Today 30-year AAA Muni Bonds earn 3 percent tax-free. Your 3 percent tax-free bond interest will pay all of the 2.88 percent net loan costs (interest), leaving you a small profit of 0.12 percent; but that is before adding the extra profit generated by inflation. That’s right, I said profit.
In our savings example in my last column, inflation was our enemy. It took away from our profits because it decreased the value of our money tied up for the year. However, when you borrow money, the dollar the banker gives you today will buy more than the dollar you pay him back later. This is due to the very same principle we demonstrated in the savings example. Ask yourself: Would you rather pay your current house payment today from your current earnings, or the exact same size house payment in 25 years with whatever your salary has grown to then, due to inflation? Obviously, you would choose the future, right?
So to wrap things up, we take the profit we earn from inflation, which is 2 percent this year, and add it to the 0.12 percent profit we got by subtracting our net interest cost from our net investment earnings, and we have a 2.12 percent gain. However, that is a 2.12 percent profit, after tax and after inflation.
Now, would you like to take a guess of what your bank would have had to pay you in interest on a savings account for you to have netted 2.12 percent after taxes and inflation? The answer is 5.72 percent!
If you had earned 5.72 percent interest from the bank, in the 28 percent tax bracket, you would have to pay 1.6 percent in taxes, leaving you 4.12 percent. If you then deducted a 2 percent loss in purchasing power for inflation, you would about 2.12 percent left after taxes and inflation.
What is more important is, let us not forget that today we are at the lowest interest, inflation and safe investment rates in decades. In this example, our home loan interest, which is our only cost or disadvantage, is locked down for the next 30 years due the terms of the loan. However, inflation and investment yield, for our two friends in this example, are most probably going to go up substantially during the next 30-year period. These future increases will mean significant additional profits.
Therefore, this is a great example of what I mean by Good Debt.
Now, let me give you an example of Bad Debt. Suppose you borrow money you did not have on your credit card to buy some clothes, and the interest was 18.5 percent.
Credit card interest is not tax deductible, so the interest costs you the full 18.5 percent. Since you bought clothes with money you did not have, there is not any money left over to invest, so your net investment income for the formula is zero. Now, inflation is still your friend in this example, so at the assumed rate of 2 percent, the net cost of borrowing is still 16.5 percent. That is a very real loss of 16.5 percent, which is what I call very Bad Debt.
This whole concept can boggle the mind a bit, and certainly goes against what most of us were taught is right. However, once you start working with the Good Debt/Bad Debt formula, you will quickly see that it will always tell you what to do, no matter what financial environment your find yourself.
The important key in using this formula is to always remember that if you add in an investment return from having invested the money, instead of paying cash for the item, you then have to actually make those investments and earn that money! Otherwise, you are only cheating yourself; because if you ran the same formula without the investment return, the formula would have told you to pay the money toward the debt instead.