Ask Adrienne: Money 2 – Debt

When the topic of money comes up, I find the conversation quickly turns to debt. How to get out of debt? Good debt vs bad debt? Is there such a thing as good debt? And how did I get this far in debt?

Let’s start at the beginning.

How do you get into debt? What is debt?

As stated in first part of this trilogy, debt means you have consumed more value then you have contributed. You buying and spending exceed what you give back to the world.

Debt comes in all shapes and sizes:

· Borrowing 5 bucks from a friend at lunch

· Borrowing money from family and friends

· Student loans

· Car payments

· Credit cards

· Home loans

· Line of credits

· Now, you can even go to a local quickie loan and write them a check that they will cash on pay day and they give you money right away – minus there charge of course.

These days we teach kids really early that debt in ok. “Fine, you can have it, but it is coming out of next week’s allowance” or “you can pay me back when we get home.” I am not saying this bad, but simply posing the questions: were you aware? Was the kid aware on same other level other then I got what I want?

In the states, debt is started young. Companies target college kids for high interest credit cards, card loans, and student loans. As you get older the amount of companies who want to lend you money is grader because now they want to lend you money for home loans and goodness knows what else. Before you know it, you have more debt then you can imagine.

What is to be made of this? First, learn to say no. Just because a bank is willing to lend you 200K for a new home doesn’t mean you can afford that. Banks, credit card companies, and other lending institutions will give you more then you can afford because they make more money. Remember, everything you barrow you have to pay back with interest, so determine if the pay off is worth it.

Good Debt Vs bad debt

I have heard lots of talk recently about people talking about being in debt, but they think that’s ok because it is good debt and good debt must be ok. Good debt is often considered home loans and student loans. Home loans because they have low interest rates and are tax deductible. Student loans because the interest rate is very low. Credit cards and other high interest (over 7 percent or so) are often considered bad debt because of how much money is spent on paying interest and how little is spent on paying principle.

Lets play with numbers.

Let’s pretend that I am going to buy a house. I am going to take out a loan for 200K. At the time of this writing, you can deduct interest on loans up to a million dollars loans on your taxes in the United States.

200K paid over 30 years at 6.0 % interest:

I pay 1199.10 per month

I pay 231,676.38 in interest over 30 years

Lets say now, I am making my house payment no sweat and I decide to make double house payments.

I pay 2398.20 per month

I pay 59,428.74 in interest over 9 years and 1 month.

After those 9 years I stop getting a tax ride off as well.

Now let’s say instead of putting that money into paying off the house, I instead invest it. Now personally, on average I earn about 18-20 percent a year on my investments, but I know the rule is 10 %. So for the sake of this, let’s say you get 10 % interest per year on the money you invest.

If I put 1199.10 a month into investments after 30 years, I will have 1,861,877.97 (factored in 25 percent tax per year). That’s a lot :D

Now, if I paid off the house instead then put double into investments. After I paid off the mortgage, it would look like this:

If I pay 2398.20 a month into investments for 21 years I will have 1,601,720.39 (factored in 25 percent tax per year).

That is a 260,157.85 dollar difference.

This is what it boils down to:

In 30 years, I end up at the same place with the house paid off and investments. I paid out the same amount. Each month 2398.20 was either invested and/or used to pay off the loan. Even tho I paid a lot more in interest to the bank, the extra investment interest more then made up for it. On top of this I have all the money I saved in taxes because I tax deduct the interest over 30 years not just 9.

To me, 260,157.85 that is worth it. You have to make your own choice.

The idea here is that some debt allows you to accumulate wealth while others only help you stay in debt. You actually make more money being in debt then you will if you pay it off. While these numbers are true, if you don’t have the self control to invest and instead of investing buy TVs, boats, etc, then choose to pay off your loans first. What I am talking about is a great idea in theory but for many people is hard to execute. Why? Self control and short term thinking. I will touch on that more in future posts.

Now, I hate debt. I am not in it, I don’t want to be in it. I avoided student loans like the plague choosing instead to work more then full time. When the time comes for me to buy a property, I will take out a home loan. I will take 30 years to pay the loan off, I will take the tax break, and I will invest like crazy. I already invest like crazy so that wont be too big of a change.

 

Adrienne :)

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6 Responses to “Ask Adrienne: Money 2 – Debt”

  1. [...] it and there is a lot of math in it for you, but it should explain the point i was trying to make. Adventurous Philosopher Blog Archive Ask Adrienne: Debt – Money 2 Adrienne __________________ Adrienne Adventurous Philosopher — My [...]

  2. Uncle says:

    You are right- there are two types of debt- Substantiated (homes, lines of credit, cars) and unsubstaniated debt (credit cards).

    Homes, cars, etc- are assets that have value- Depending on capital, cash flow, etc- those assets are sources of cash- During recessions, and (worse )inflationary times- those assets enable you to free up capital- it’s especially helpful when people lose their jobs, or wives have children, (or when relatives come to live with you for a couple of years) etc- to have liquidity of those assets- It’s neither good nor bad debt. All debt is probably bad when you look at it- but necessary depending on the situations and the kind of lifestyle you are trying to maintaining.

    Your business model is pretty good- with the exceptions of the variables of market performance and inflation- The $260K does not have the same value in 2037 as it does in 2007. There are market adjustments that can also effect that flow- That interest rate on a stock or mutual fund will vary quite a bit. The same is true with housing prices- but there is much less variance in real estate (as long as you dont live on a coast) than there is with the stock market.

    What makes the most sense is whatever house you buy, you need to buy it on a 15 year mortgage, and it fits within your cashflow- The two biggest mistakes that someone can do is buy an adjustable mortgage (with PMI) and buy in an area that is too affluent for their pocketbook. That is where they start to borrow to keep their lifestyle afloat- and the trouble begins-

    As usual- great post!

    U

  3. Adrienne says:

    Uncle
    Market performance and inflation happen regardless of which way you go.
    You got a little ahead of me there. I will be touching on living within your means and saving next post.

    Thanks for the through analysis.

    Adrienne :)

  4. Uncle says:

    Sorry for getting ahead of you-

    What has always worried me is how people feel very comfortable using asset debt as a source of income towards investments- It’s kind of a house of cards mentality that is engrained throughout the USA. I think a lot of it is how our economy is structured. We don’t reward people for saving- In fact the tax laws almost penalized them in some respects.

    I think a lot of it goes back first settlers- Leaving Europe to come to the New World- People in American love to take risks, gamble and hope they will all be millionaires!! LOL!

    Anyway- Thanks for making me think!

  5. Adrienne says:

    No worries. It provides a nice transition to the next post.

    You’re completely right. We don’t reward saving, investments, or planning for the future nearly as much as we should. Heck, our very economy is based off debt (look how much in debt the US government is).

    It worries we as well the amount of people who rely on the equity of a house going up so they can take money out to live. Unfortunately, this trend seems to be increasing.

    America seriously needs a money wake up.

    Adrienne :)

  6. [...] Adventurous Philosopher Thought is the only matter var sc_project=2403862; var sc_invisible=0; var sc_partition=22; var sc_security=”dd3c29d3″; var sc_remove_link=1; « Ask Adrienne: Money 2 – Debt [...]

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