Problem #60: If you have any debt at all, even a mortgage, you are currently borrowing to buy everything.
After a statement like that, I’m sure you’re expecting an explanation. Or maybe you’re thinking, “Surely you jest?” Actually I’m not “jesting” . . . and don’t call me Shirley. But let’s talk about maintaining debt. Actually I’m going to try and convince you to prioritize paying down your debt. . . just so you know.
Let’s look at a hypothetical scenario – or maybe not so hypothetical. Suppose you have a mortgage on your house of 150,000 at 4%. You have a car note of $17,000 at 6%. This makes your aggregate interest rate 4.2%. I think this is fairly typical situation. You may have more, or in a better case, less debt. The good news is; you also have a healthy “money gap”. Good work!
But we still have a PROBLEM. You see, you still don’t understand how debt works.
Let’s explore this a little bit with some assumptions and using some hypothetical situations. So bear with me. By taking out a loan, you are buying something now that you don’t have the cash to buy. I think we all understand that. So you are exchanging your future money for something you want today like a house or car. The key here is “future” money. Because we’ve already established that you don’t have the money available today.
Using this future money comes at a two-fold cost. Not only can you not use that future money for something else – it’s tied up in debt repayments, but you also pay extra for that privilege. The “extra” is interest. In this case – 4.2%.
Are you still with me?
It follows that any money that you have today, right now, will have that cost associated with it. For instance, if you were to put it towards your debt, you would get a 4.2% return. You benefit by doing this, because you are saving future money from being paid by paying your debt early. But here’s the thing, if you don’t put it towards your debt, you are losing that 4.2%. This is the cost of choosing anything over debt re-payments.
So when you buy groceries and gas for your car, you are losing the benefit of saving future money – to the tune of 4.2%. But, but, but – these are necessities! Sure they are, and you do have to eat. But this is the cost of maintaining debt.
Think of your latest grocery bill. Ours was $119.65 at Aldi’s (which we love by the way). But that money is not going towards debt, so it comes at a cost . . . 3.875% in our case. So it really is like paying $124.29 for our groceries instead. An added $4.64/week. This is our cost for groceries. Yours may be different, depending on the interest rate of your debt.
Every time my wife buys groceries, she says, “I only spent $119.” Which is great, but it actually means those groceries cost us $125. Ugh. Because – debt – mortgage.
Which may not seem like much, but $4.64 compounded at 7% over 10 years is $3,494.
So there is a cost to maintaining debt, but what if you could re-coup some of that money? Or course I’m talking about investing instead of paying down debt.
You’ve heard the argument that many use when they are trying to justify investing instead of paying down their mortgage. They say smugly, “I’m at least as smart as Warren Buffet, so I can get, oh, at least a 15% return on my money in the stock market. Why should I pay off my 4% mortgage?”
Okay so no one I know claims to be as smart as Warren Buffet, but they do claim to be able to get 10-12% in the market.
So Does Investing Instead of Paying Down Debt Make Sense?
First, let’s just establish that you’re NOT Warren Buffet! You’re a regular
Joe – I mean Chris – like me. The odds of picking single stocks are not in our favor. Every so often, someone hits it big by betting on a new startup company that does well. Think: Apple or Microsoft in the 80’s. Or Amazon, Ebay, or Google in the 90’s. But it probably won’t happen to you.
But the fact remains that you can do better than 4%. Historically, the market has averaged 7% (after inflation – not 12%) – which is indeed higher than 4%.
But you’re only netting a 3% return, because of the cost of maintaining debt. All the while you are spending like an oil sheik who just discovered Amazon.com. Depending on the ratio of your spending vs investing, you’re probably not even breaking even.Are you spending like an oil sheik who just discovered Amazon.com? Click To Tweet
So, if you could invest All your income at 7% while you paid the minimums on your debt, then it would make sense. But NOBODY does this. Because of course you have to eat. So any money that you don’t invest or use to pay down debt has an extra cost to it.
The only investing that I know of where you are guaranteed a rate high enough to justify investing is inside your 401k to maximize the employer match. This return is simply too high to ignore, and most likely covers the cost of spending for necessities.
Outside of that, – PAY DOWN YOUR DEBT AS FAST AS POSSIBLE!
I already have debt, what should I do?
After you buy the necessities, you need to concentrate on eliminating debt. You see debt is an enjoy-it-now-pay-later system. It’s a giant pyramid scheme that you are building. Once you start using debt, you are paying for things today with tomorrow’s money. And these are things you need. Of course you need to eat and have shelter. But by keeping debt around, you are doing it (existing – or living) in the most inefficient way possible.
Ok, so that’s not exactly true. You could be living in this house with 15 bedrooms and 22 bathrooms with just your wife and 1, 2 or 3 kids. But that’s not you – or me.
What you should be doing is spending today’s money for things today. That means cash only (or debit cards). Don’t risk tomorrow’s money with debt. This is how you become a slave. You have no freedom of choice, because a part of your future income is required to pay back the money you borrowed. For something that you no longer enjoy or possibly even have.
So how much is your debt costing you?
Let me know in the comments, and if you haven’t yet subscribed, please do so. It’s free, and you’ll get a e-mail every time a new post comes out. Seems much more efficient to me than having to come back to the blog every few days, and catch-up.