Is all debt created equal?
As I am in the thick of searching for a house in Orange County, CA one thing has occurred to me, owning a house means taking on a lot of debt. One of my favorite shows on HGTV attempts to change the way people live. It highlights younger age people buying tiny houses. Not sure what a tiny house is, watch the show here. It’s an attempt to do away with a typical mortgage and debt that comes with it while living in a 250 square foot house.
Although, a tiny house is a great way to avoid a huge debt, is it worth the sacrifice?
It got me thinking about the negative view we have of debt. Not just my generation of millennials but every generation. We saw our parents get a mortgage, and now we are saddled with student loan debt. We are lead to believe we should be paying it down debt aggressively, early, so that we can be free of the burden. Although, this may feel good to have no debt, financially it may make sense to just continue with the scheduled payments.
Let’s first define the kind of debt I’m referring to. The debt I am talking about is student loan debt and mortgage debt. Be aware that I am saying credit card debt should always be paid off, and you should not make minimum payments (it should be full payments)!
Back to the debt. If you have a low interest rate on a mortgage, I’m talking about below 4-5% there is no reason to lock in a low return if you can earn more on the extra payment you are making.
Let’s look at an example:
Mike has $100,000 worth of student loan debt. His payment at 6% interest for 10 years would be $1,100 a month. Right away, you see that is a lot of money to pay. But, if Mike could swing an extra $200 a month he would essentially lock in a 6% yield on that extra $200 a month. By paying down the student loan sooner he is lessening the time frame of the loan, which charges interest, thus saving him or said another way yielding him 6%.
Another way to view the extra $200 a month is if he could invest in something that produced a 7% return. You see where this is headed? There are always trade-offs in life. Sure, you would be taking on more risk by investing money to get 7%, but financially this could be a better return then locking in 6%. This would mean instead of paying down the debt faster, Mike would set aside the money and invest it (in a hypothetical investment).
There is actually a term for this concept. It is called opportunity cost. It is the idea of using your money for one thing while giving up another. Essentially, Mike is giving up a potential for 7% return by getting 6% to pay down the loan faster.
You may think this is a good deal, and it might be, but it will depend on the type of person Mike is and the risk he is willing to take. This is a big reason why it is always wise to pay down credit cards, due to their high interest rates. When a company charges you upwards of 15% it makes sense to pay down as fast as possible.
In light of all that, why should you be in earnest to pay down debt faster?
Financial planning is used to help you live the life you want now, so you can live the life you want to later. If you are sacrificing now in a big way, but it makes financial sense not to pay down the debt faster, yet still achieve your retirement goals, why wouldn’t you save the money? Carrying debt may not feel nice, but it may financially be the best option.
What do you think about not paying down debt as fast and using it to save with a better return?