Avoiding the Temptation to Pay Down Debt

I have a sickness in that I like to read inordinate amounts of personal finance material. If you too are afflicted with this malady you have no doubt noticed the repetitive nature of some of the themes that us personal finance-types love. That’s because at its base, personal finance really isn’t all that complicated. If you make more than you spend, don’t buy stuff you don’t need, and have a clue about how to invest, you will probably do just fine. One of the all-time favourites of mine in the personal finance blogosphere is the high people get from paying down debt. While most people enjoy seeing their negative balances shoot into the positive range, personal finance-types experience a certain type of unique euphoria when this happens. Naturally, I think I’m probably influenced to some degree by all these articles that I read, so I am finding myself having to fight the urge to pay down my debt.

pay off debt fastNot All Debt Is Created Equal

Why wouldn’t I just give in and join the kill-my-debt-as-fast-as-possible club? Because it just doesn’t make financial sense over the long run. Now before I explain why it doesn’t make sense in my personal situation to focus on paying down my debt, I want to make it perfectly clear that I in no way, shape, or form, suggest spending or investing if you have credit card debt, consumer debt, or basically any debt higher than about 7% interest. The ONLY time I would break that rule is if I had a quickly-growing personal business and was taking out an extremely short-term loan, or possibly if there were some great tax incentives in play. Other than that, consumer debt really sucks and is bad.

Forget About Debt! (Not Your Dad’s PF Message)

Ok, so now that we have made that clear, I want to explain why I am focusing on building our internet side business, as well as contributing to my TFSA, and RRSP accounts as opposed to putting every extra cent I can into my debt. My debts right now consist of a mortgage that is at a 3.6% interest rate (and is much smaller than most mortgages due to my geographical location), a $15,000 car loan at 2.9% (I know, I will burn in personal finance hell for this. It will probably be run by the CEOs of credit card companies), and a $10,000 personal loan at 4.9% that we are using purely to fund our business pursuits. I have no student loan debt, but if I did I would probably be ignoring that too (paying down a minimum). Surely with all these loans and the fact I rarely think about paying any of them down (although I do think about quickly combining some of them with a small Borrowell loan) I am not fit to contribute to a personal finance blog you might be thinking. You might think that, but you would be wrong.

The Bogeyman of the PF World

The reason you would be wrong is that you have likely fallen into the all-too-common psychological trap of allowing your debt to control you. Remember that money is just a tool, and that owing money isn’t really a problem as long as you have assets that are growing every day. With the long investment time horizon that I have I am very comfortable with having 100% exposure in equities. As you are all probably fully aware of at this point, I am a huge fan of passive investing in the stock market. If I can attain merely average results in the stock market, minus a very small percentage in commissions and fees I should easily be able to hit an 8% rate of return. If you don’t believe the sky is falling, I think 9% is much more likely, and 10% is not as crazy as most people think (the average return of the stock market for the last 200+ years has been 10.4%), as long as you know that your money can be left alone for at least 20 years, but I’ll stick with 8% so I can keep my personal finance blogger card. If we agree that my money can earn 8% a year in a registered savings account, then by basic math any pay down of debt that is less than 8% is not a great investment.

Taking Into Consideration…

Now I realize it isn’t quite that simple. Interest rates can rise at any time, which can quite suddenly change the equation. Also, there is an argument to be made by the fact that when you pay down debt, that is an after-tax return on your investment, versus investment returns that might be taxed at a later date. Unfortunately I don’t have nearly the income yet to worry about maxing out my yearly registered savings plans, never mind taking advantage of all the previous years when I was in school and banked all of my contribution room. I won’t have to worry about tax rates affecting my investment returns for quite a while.

When we look at my specific debts we need to look at what they cost me right now, and what they might cost me in the long term. The simplest debt is my car debt (a decision I have yet to regret by the way), which is locked in at 2.99%. If stocks don’t return 2.99% over the next 20+ years then I will erase the entire database of this blog. My personal loan (which we are aggressively paying back with our side business income just so we have some liquidity), looks fairly high at 4.99%, but one has to take into account that the interest paid on that loan is fully tax-deductible since it was used purely to fund my business (it is considered an investment loan, and yes I have the paper trail to prove it). Therefore, it is a “real” interest rate of more like 3.7% or so. That debt is tied to prime rates, so it could rise, but at our current rate of paying it down, it should be gone before we see 2013, so I’m not all that concerned about it (one could make the argument we should forget about it and look for more assets to purchase actually). The most complicated debt is the mortgage debt. Obviously this debt has to take into account a much longer time frame. This means that it becomes extremely difficult to predict future interest rates. I am almost completely certain that prime rates will not rise more than .5% in the next two years, because our dollar simply couldn’t take that high a valuation versus the USD. After that, it is notoriously tough to predict interest rates, but since my mortgage only has about 84K left on it, I’m not overly worried.

What We Can Learn From Corporate America

When interest rates are this low and so many assets all around appear to be either undervalued, or modestly valued, good businesses take advantage and don’t hesitate to take out debt if it is advantageous. The principle of purchasing assets as opposed to paying down low-cost liabilities is applicable to personal finance as well as businesses. Now if you solely focus on getting out of debt as quickly as possible and trying to avoid it at all costs, you will probably be just fine in the long run, but you won’t have maximized your money/tool’s potential. The whole point of me knowing about money is to use the tool to increase my happiness in life. The best way to do that right now is to invest in assets that have an 8% return instead of paying down liabilities that would be equivalent to a 3-4% return. It really is that simple, no matter what your PF blogger-influenced conscience tells you!

 

22 Comments

  1. Lance@MoneyLife&More on July 1, 2012 at 9:10 pm

    Thank you for writing this post. I thought I was alone! While high interest rate debt should be paid off immediately after that it is purely up to the person and what they are comfortable with. an argument could be made either way depending on your risk tolerance but paying down the mortgage isn’t always the smartest move.



  2. Joe on July 1, 2012 at 9:52 pm

    Leverage for a business isn’t necessarily a crime against the PerFi gods. If you listen to Warren Buffett (one of the recommended posts underneath the post when I view it is “I heart Warren Buffett”) then you would never leverage for a business.That way you could lose your invested capital, but nothing more, and certainly not the bank’s money. Sure, the interest can be discounted against the business income on taxes, but you’re still paying much more interest than you’ll get back in interest. It’s extra potential return out the window. That said, if you didn’t have the cash to grow the business, you wouldn’t enjoy additional profits (assuming the investment yields attributable additional profit). Leverage amplifies both returns and loses — it amps up the risk/return equation on both sides. I’m not going to say it’s good or bad in your scenario. You’re a much better judge of that.

    The car loan though? Come on, man! A $15,000 loan?? What’s your car worth? $20k? I hope not $25 or $30! Given that it’s a massively depreciating asset, I think the claim that you shouldn’t pay it down (regardless of whether it’s 2.9% or 7%) is just bunk. You can get a reliable car for under $5k and spending $15k+ when you have other debt just isn’t the way to get rich. Debt like this is just consumer debt. It enslaves you to somebody else. Get rid of it! I drive an 03 Malibu; debt-free for life, man.

    Do you have a sizeable emergency fund? I’d say having enough cash to make debt payments for 3 – 6 months would be the best way to *mitigate* the risk. Again, the best way to eliminate the risk is just to pay that car loan off.



  3. Teacher Man on July 2, 2012 at 12:08 am

    Thanks for backing me up Lance! Money is just a tool at the end of the day, it doesn’t deserve to be worshipped or feared.



  4. Teacher Man on July 2, 2012 at 12:21 am

    While I also am a huge Buffett fan, I definitely differ from him on this point. Nearly every entrepreneur or small business owner uses leverage and responsible use of debt at some point to grow their business. My point with the taxes in regards to interest rates was that the raw percentage you are paying is not the true cost to you because of tax considerations.

    Interesting line of thought here Joe. So you would be in favour of paying for a car with 20K down, when they are letting you borrow the money for 2.9%? That makes absolutely NO SENSE! Do you truly believe that you can’t find investments that will return more than 3%?! If you can, then take the money and run! It is basic math man! To answer your questions, my car is 20K, it is a Hyundai Elantra, and trust me, I ran all of the numbers, and the used car market does not support the “common sense” that has been espoused for years. I also plan to drive it until it dies, so I don’t really care much about the depreciation. Consumer debt at 3% is still money you have borrowed at almost no cost! This is the sort of PF logic that simply does’t bear out. The fact is that a 5K Malibu has a huge cost of ownership, and terrible fuel efficiency, it does not make sense over the long-term.

    I have an emergency fund of about 3 months expenses, but to be honest, I would not hesitate to spend it if the right opportunity came along because I have one of the most stable and secure jobs in the universe – school teacher.



  5. Joe on July 2, 2012 at 11:34 am

    Can you write off the interest expense for your car? Nope. Can you get a RISK-FREE, AFTER-TAX return of 3% in this market? Double nope. Throwing away after-tax dollars to pay interest on an overpriced import, so you can invest in taxable investments? Brilliant.

    An 03 Malibu would be much less than 5k. I was just saying 5k b/c you’re obviously committed to paying too much for a vehicle. I paid less than $1k and I baby it, which has cost me -maybe- a couple hundred bucks. I’m also not paying $600 a year in interest for the right to be a debt slave. I realize you’ve drunk the import koolaid, but the depreciation on a new car will vastly outmeasure any fuel savings unless you’re a long haul trucker. I won’t even get into the fact that many new domestics offer amazing mileage. Let’s have a contest — who can keep, as their only vehicle, their car for a longer time, starting today: you or me? I’m at a model-year disadvantage of a decade and I’ll bet the buy-a-used-domestic will STILL come out ahead. Your depreciation in the first half a year was higher than a grand.

    Of course the smartest option is just to not own a car. Unfortunately I live in the kind-of country and I take it you’re remote, too.



  6. femmefrugality on July 2, 2012 at 12:53 pm

    I have a car loan, too. I view it a type of investment…by having a nicer car, I don’t have to plunge into repair costs every month. I’ve been spending less per month since I took out a loan on my car. Granted it’s always going to be of depreciating value….

    I think it’s when debt starts taking over your life that it becomes a problem you need to pay off STAT. If you don’t have enough resources to cover your spending habits or your student loans, you’ve got to change something, and being drastic about it is certainly the most efficient way to do that for most people.

    But you’re also absolutely right. If you DO have enough coming in to cover your debt, taking your money to grow in an account that has a higher interest rate than your debt costs you is certainly the better thing to do according to the numbers.



  7. Kathleen @ Frugal Portland on July 2, 2012 at 1:05 pm

    Where else are you getting a guaranteed 4.9% return on investment? That’s my problem — I know that I might be able to find something better, but my student loan, at 4.25% is absolutely guaranteed.



  8. Teacher Man on July 2, 2012 at 3:19 pm

    Hey Kathleen, is student loan tax deductible in the USA? In Canada it is, so therefore I get back the equivalent of my marginal tax rate on any interest I pay on my student loans (although I don’t have any). If you took 4.25% as the figure, I would have a “real” interest rate of about 2.9%. If stocks don’t get you at least 7% over the next 30 year rolling annual average, it would be the worse stretch in the stock markets history. You can’t really go wrong getting out of debt, I’m just saying that you could do better!



  9. Kathleen @ Frugal Portland on July 2, 2012 at 3:35 pm

    Yes, in the US you can deduct student loan debt, but for me, that still puts me at 3.6%. I figure, as soon as I’m out of debt, then I can start saving and investing, but can be riskier when I don’t have to compare against guaranteed returns.



  10. Teacher Man on July 2, 2012 at 3:39 pm

    Joe, please justify the numbers your throwing out there. I don’t care if returns are risk-free or not, I’m looking at the long-term since I’m 24. If you can’t get 3% returns in the stock market over the next 30 years it would the worse 30 year rolling average in the history of the stock market. Your comparison might almost be valid if there was no such thing as registered savings accounts, but as I’ve pointed there definitely is.

    I have no idea how you paid less that 1K for a vehicle, there is certainly nothing like that near the market I live in. With so many people just like yourself touting the idea of used cars, the cost of ownership, better fuel mileage, guaranteed warranty, and subsidized interest rates, mean that new cars are actually a bargain now.

    I have absolutely no problem with your contest. I would give myself a 95%-97% chance of victory given how badly foreign cars have beaten up on domestics over the last couple of decades, and my determination to drive this car until it dies. I’m no mechanic, but I am anal about maintenance (to the point where I actually spend too much most likely). I’m quite certain a 2012 Hyundai Elantra will not loose to an ’03 Malibu. It has better mileage that domestics, trust me, I checked out the Cruze, and while the new Focus wasn’t out at the time (and is probably a better comparison) it beats that as well.

    I don’t know where I even start with the figure of $600 and the term debt slave. My loan is for 3 years at 2.9%, and I will pay under $700 in interest over the ENTIRE LIFE of the loan (3 years). It is not I who is drinking the Kool-aid my friend. It is yourself who has become a slave to conventional thinking about debt and money. Once again you reference depreciation which is completely irrelevant to the argument because I plan to drive the vehicle until it dies, not sell it after 3 years. Go ahead and check out how much Hyundai, Honda, and Toyota cars have depreciated at the 2 and 3 year mark anyway. The old stats are being proven wrong in this market.

    We agree that the best option would be not to own a car, however living in a rural location it is a non-starter for me. On the plus side my house cost 95K!



  11. Teacher Man on July 2, 2012 at 3:43 pm

    The subsidized loan rates on today’s new cars, in addition to their advantages, plus the thin used car market have made owning a new car the financially smart thing to do. I agree, not spending time in the shop is worth a premium to me as well, but the funny part is I don’t even have to rely on that justification. Why people stress over paying back 0.9%-2.9% interest loans that aren’t tied to prime rates makes no sense to me at all. Money is just numbers, it is just a tool.



  12. Teacher Man on July 2, 2012 at 3:46 pm

    In the end most people would suggest you should do what lets you sleep at night. I would suggest you should sleep easy investing in high-risk investments at your age as long as they are diversified. As your income grows (as one assumes it will) your marginal tax rate will also climb. It’s up to you, but I have a lot of other places I’d put my money in life rather than sweat over 3.6%. On the other hand, I don’t know your personal situation, how much debt you owe, or what your cash flow looks like, so an ultra-conservative strategy might fit best for you.



  13. Kathleen @ Frugal Portland on July 2, 2012 at 4:03 pm

    Right, I know it’s conservative, but I see it as one less thing to worry about and it’s a relatively quick win — but I think if I were 24, I’d take more risks. In fact I did! And lost. But that’s part of risk-taking, if people didn’t lose, it’d be called sure-thing taking.



  14. Teacher Man on July 2, 2012 at 5:10 pm

    If you don’t mind me asking, what risks did you partake in? In my opinion investing in the broad indexes is only a risk if you need the money in the next 10-15 years.



  15. JP @ My Family Finances on July 2, 2012 at 7:52 pm

    The risks here aren’t all that different than buying stock on margin (we are of course assuming you could be debt free if you tried). Buying on margin is extra good in the good years and extra bad in the bad years. This is important to note on the term of the loan you are taking.

    For example, a car loan that is 3 or 4 years is risky to be dabling in the stock market. You might risk buying on a peak and taking a big hit. A 30 year mortgage gives you the largest potential of taking adavantage on what you are talking about. A student loan at 10 years, is probably ok.



  16. Teacher Man on July 3, 2012 at 8:11 am

    Hey JP, I hear what you are saying in terms of investment time horizons, but it’s not really comparable to buying on a margin at all. For one thing, the rates of interest on margins are usually higher. More importantly, margins can be called in at any point and force you to sell an the most inopportune time possible.

    The length of the loan I am taking out is irrelevant because I plan to be invested for 30+ years. It doesn’t really matter how long it takes me to pay off the loan, because it isn’t like I am going to withdraw the money from investments at the end of the time.



  17. JP @ My Family Finances on July 3, 2012 at 8:48 pm

    Some very humble criticism. I do think your overall point is absolutely right on. Most people are missing out on some potentially large debt benefits. However, I believe you are failing to see the opportunity costs in this scenario and therefore some of the more immediate risk.

    You see, the term of the loan does matter. Depending on how you want to set up the scenario, you are essentially using a loan to invest today, the money you’d invest at the end of the loan. The benefit for which you are paying interest is the ability to invest money earlier and take advantage of an interest spread.

    Since you plan to invest today and the opportunity you are foregoing is to invest at the end of a loan term, you have the term of the loan to earn a favorable spread on your arbitrage. If you earn less than the spread, then your gains are going to be less than if you’d paid off the loan no matter how long you hold the investments.

    While I do agree that your scenario is not exactly like borrowing on margin. Your risks truly are similar. You risk paying interest even though you might be taking losses or receiving greater gains by having a larger pool of capital. I don’t know about Canada, but in the US, many loans can be called in at any time. Interest rates on margins are indeed higher and you also need to hold capital requirements which is also a difference.



  18. Teacher Man on July 3, 2012 at 11:15 pm

    Ok JP, I think we’re more on the same page now. I follow you that by taking out the loan I am using that money to invest today. I also agree that the interest spread would be my real return on that “loan” and subsequent investment. I see where you are coming from in that regard. I guess the point I was trying to make is that regardless of where I stand at the end of the loan, I don’t have to realize either the losses or the gains (in fact, I almost inevitably won’t), so therefore the idea of comparing the two at that point is irrelevant. The added benefit is that I am giving myself more years in the market with which to moderate “volatility” and giving myself a greater chance of realizing the historical average gains of the asset class.

    I’ve never heard of a bank in Canada calling in a car loan, I’m fairly certain the contract is very explicit on the length of the term. I could be wrong (not a lawyer) but I don’t think it is possible.

    The other disadvantage of a margin account is that most brokerages (the ones I am familiar with anyway) won’t allow margin trading within a registered account. This would take away the tax advantage and render a whole different argument. There are many more differences than similarities in this situation. The core idea of borrowing a secure loan, at a very low interest rate, and investing it in a broad index of equities is much different than opening a trading account on a margin in my opinion.

    Thanks for clarifying everything, I enjoy the conversation!



  19. JP @ My Family Finances on July 4, 2012 at 12:02 pm

    I definitely agree. I think this is the most indepth commenting I’ve ever done. You’ve inspired a post at my blog; I hope you’ll come check it out when I get it up.

    I do know where you are coming from – you are going to hold on to the investment until you get a good return, so there isn’t likely a risk of loss in your scenario. That is what makes what you are proposing a good risk. I am completely on board. I think what you are proposing should be considered and followed far more than people currently do.

    However, you do risk taking a potentially big hit compared to the returns you could have made investing at the end of a loan, because of market volitility during the term of your loan. Take the lost decade in the US stock market. If you used loan dollars to invest in 2001, you are not any better off, even thirty years from now, than if you bought into the market in 2011. The only difference is that you paid interest to invest in 2001 and no interest if you waited until 2011.

    Let’s go to the other extreme:

    You don’t want to get a car loan because you have the $5,000 you need, but you were planning on investing the money today. Instead, you will use your bonus check which arrives tomorrow. The problem is you have a good deal on a car today. Looking around, you find a great deal on a pay day loan that is only 2%, the 30 year average for the stock market is 7%. Should you invest today with a 2% pay day loan or tomorrow when your bonus check comes in?

    Take note, the market prices will be very different today than tomorrow, because of market volitility. Say you use the pay day loan to invest today and the stock market drops 50% tomorrow and quadruples on day three. Either choice would make you money, but you would have made more if you’d invested tomorrow instead of today, so it really wasn’t worth paying the 2% interest. It’s not a given that this will happen. The market could double tomorrow and double again the day after that in which case the pay day loan scenario is far better. However, I think you can agree that market volutility creates a risk in investing literally today instead of tomorrow and it’s no different in investing today or four years from now.

    The longer the term of loan, the more you are likely to do far better in this strategy than jumping into the marke with the same money later. A 30 year mortgage is pretty much guarranteed to give you the 30-year average market return and the spread you are looking for. In the lost decade example I gave earlier, you are worse off. Time is the key to minimizing risk.



  20. Teacher Man on July 4, 2012 at 2:15 pm

    I see what you are saying JP, and I guess we just have different ways of valuing the risk involved at taking a loan out at 3%. You’re definitely right in what you’re saying, and I’m glad we agree that I’m doing the right thing! I’ll definitely check out your post when it goes up. Thanks again for stopping by.



  21. The Passive Income Earner on July 6, 2012 at 5:41 pm

    I think it’s important to look at debt load from many lenses. Your situation is very clear in that you are young and have a much better job security and pension plan than others. All that taken into consideration really changes how one thinks about debt.

    I’ll use me as an example, our company did layoffs for 5 years running now. Luckily, I was not impacted but I have become much aware of my debt service level at my current income (which is very fine) but if I were to have a reduced income due to a layoff, that would change. With a family of 4 and only one income, the risks are different …

    My appetite for debt servicing has changed dramatically as my family has been growing.

    Just my 2 cents.



  22. Teacher Man on July 7, 2012 at 9:21 am

    Yah, that definitely makes a lot of sense PIE. I definitely agree with you. I am in a somewhat unique position as my living costs will almost assuredly be low for my entire life due to the fact I like rural living, and fairly unparalleled job security. With the spectre of a lay off looming over your head and a family to look out for, I understand the difference.



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