March 31, 2019Individual Investment Management

Paying Off Debt - All debt is not created equal.

The often-repeated mantra that "all debt is bad debt" demonstrates a fundamental misunderstanding of how money really works.  Here are 3 things to consider:

1.  It's just a tool.
The apt analogy here is that of a kitchen knife.  Kitchen knives can be dangerous, but incredibly useful when applied properly.  Debt is a useful tool to get what we need in life.  If it is abused and disrespected however, it will hurt you.  Debt is a tool available to you - nothing more, nothing less.

2.  It's ultimately cheaper.
A fundamental rule of finance is that it's cheaper to use someone else's money than your own.  Why?  Because your own money has a higher required rate of return and can be invested for a higher return than debt costs you.  As an investor, my job is to maximize growth of my assets - not cut costs.  Having a small or reasonable level of debt is required to buy a home, run a business, or provide for life's essentials.  It allows me to use my own money to invest in other businesses or profitable long-term ventures.  The amount I will earn long-term in asset growth is greater than the amount of money I will lose to borrowing costs.

3.  It's often deductible.
The interest on debt associated with life's largest purchases is often deductible.  Interest on home mortgages, business loans, student loans, and other loan types are (at various levels) deductible to you the taxpayer.  This reduces your cost over the long run.  In contrast, there is no tax deduction available for lost asset growth you didn't earn on investments because you were too focused on paying off debt quickly.  

A Simple Example....
Imagine you're 10 years into a $200,000, 30-yr mortgage at 4% fixed.  You now have the ability to take a lump sum of $20,000 and pay against the loan balance.  Doing this would save roughly $21,000 in total interest costs over the remaining loan life.  Sounds good right?  Hold on....

Imagine you took your extra $20k and invested in a broad-based market index or low-cost fund.  Assuming a 20-year horizon (till the end of your loan), and assuming you could earn 7% annualized (less than historical average for the market over any 20-yr time frame), your investment would grow to over $77,000 by the end of your loan.  In this very realistic scenario, your growth on assets would yield an extra $50,000+ by simply understanding the mathematics of your opportunity.