Thursday, August 18, 2011

Debt for most makes no sense

Debt only makes financial sense in one instance – when you’re consciously using it for financial leverage and expected, risk-adjusted, rate of return of the investment is higher than the cost of financing the debt plus all of your capital is employed in higher yielding investments.  So, assuming all of your money is invested in very high-yield investments, it makes financial sense to buy a house with a mortgage when it’s cheaper than renting, all costs accounted for, or when the combined housing savings and expected appreciation (adjusted for risk) of the house is higher than the interest you’ll pay on the mortgage.

If you’re looking at putting some clothes on a credit card at 20% because you think they’ll increase your chances of landing a higher paying job, you need to get specific.  Let’s say the clothes will increase your odds of landing a job with a $5000 pay bump from 20% to 25% and you want a one year break-even on the clothes.  That pay increase would become something like $3750 after taxes and your clothes give you around a 5% shot at it.  Their yield is $187.50.  Your break-even budget for the clothes is $156.25 (including sales tax) if you plan on paying off the balance within a year.  Putting a $500 suit on the credit card for your interview would not make sense in this case.

Taking on interest-bearing debt doesn't makes sense if you have cash sitting idle in a checking account earning .05% interest.  (Assuming your credit line is always available – it’s more complicated than this in reality but for most it’s a good rule of thumb)  That money is significantly cheaper for you to use than any just about kind of financing available.  The exception is 0% financing or subsidized loans, assuming you pay them off just before they start to accrue interest and don’t rack up any fees.  Remember that you should also be accounting for risk in your returns.  That credit card, mortgage, or student loan interest rate is a guaranteed cost.  Is your return guaranteed?  Almost always the answer is no, so is the return high enough to account for its risk?

Let’s look at this another way.  Financing purchases that are fun, clothes, eating out, and what not reduces the fun you can have until you pay the debt off and overall during your lifetime.  Basically you have less fun if you have debt because your discretionary income is split between paying for fun you could currently have and paying interest and principal on fun you’ve already have.  Because this problem compounds, the longer you accrue debt, finance your fun, the more rapidly your potential future fun diminishes. You have to pay your balance eventually (assuming you don’t go bankrupt).

So there are significant financial and emotional benefits to avoiding debt and if you’re someone who wants to maximize their fun in life but has trouble with the plastic you should absolutely cut up all of your cards right now because all you’re doing is reducing the fun you can have later. Breaking the cycle of living above your means will be the least costly and painful the sooner you start it.

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