Sunday, July 8, 2007

Don't Pay It Off... Just Yet!

Hello everyone.
I hope you all enjoyed the fabulous weather this weekend. Tonight's post is about how to use your debt to your advantage.

One of the main aspects of becoming wealthy and free from financial worry is getting rid of your high interest credit card debt. And I completely advocate it. Oftentimes, credit cards carry nosebleed interest rates ranging anywhere from 14 to 30%. The reason that one would want to pay these debts off quickly is that it is difficult to earn a rate of return that matches these interest rates. That is, when you pay off high interest credit card debts, you can think of it as earning that particular rate of return on your money. (If you owe $2,000 on your credit card at a 20% interest rate, when you pay off that debt, you have effectively earned 20% on your money.)

And let me repeat this again. Pay off all of your high interest credit card debt as soon as possible! It's impossible to be financially healthy while carrying debt that accrues interest at double-digit interest rates. However, there are many people who believe that ALL debt is bad and that you should pay it all off as soon as possible. I disagree, vehemently.

Yes, having to service multiple debts/give money to creditors means less money flowing into your pockets each month. However, if the interest rates on your debt are lower than the rate of return you can earn elsewhere, then you should make the minimum payments necessary for debt service, and place the bulk of your money where you can earn that higher return. Let me explain.

Fortunately, I have been able to consolidate a portion of my student loans at a great rate of 3%. But for the purposes of this example, let's assume that this is the prevailing interest rate on all of my student loans. 3% is fairly low (almost the long-term inflation/GDP growth rate) and over any twenty-year period, stocks have outperformed any other investment vehicle, growing your money by about 9 - 12% a year. So if I decided to put all of my money toward my student loan payments, I would be giving up an extra 6 to 9% (9% - 3%/12% - 3%) that I could be making in stocks. Student loans, which many financial advisors describe as 'good debt', is one of the few instances in which it doesn't make good economic sense to get rid of your debt as quickly as possible. And before I move onto the next instance where it is good to delay paying off your debts early, I would like to add that 10 year Treasury bonds - bonds that are backed by the government and guarantee principal repayment and interest - are currently yielding a little over 5%. So owning bonds right now is effectively a risk-free way to beat the interest rate on those above-mentioned student loans. And you don't even have to be in stocks - an investment that does carry risk of loss of principal - to do it.

The second instance in which you should make the standard debt-service payment and put the rest of your money toward a higher-returning investment is when you have a mortgage. Standard 30-year mortgages usually carry an interest rate of anywhere from 5% to 9%, depending on the 'prime rate' (a benhcmark interest rate determined by Ben Bernanke and the Federal Open Market Committee), and your credit rating. Assuming you have a relatively high credit rating (anywhere above 700 on the 350 to 850 scale, which is what we strive for here at Gen Y), and the standard 10% downpayment in hand, you will more than likely get a mortgage with an interest rate of about 6.5%, with today's prevailing interest rates.

As I mentioned before, it is possible to assemble a portfolio of stocks that will yield approximately 9 to 12% over the long-term. When you couple this with the fact that real estate investments appreciate over time at varying rates and the fact that the government gives tax-benefits to homeowners, it does not make sense to get rid of your mortgage as fast as some are apt to do. Your money has better places it can go. Perhaps if you place those extra mortgage or student loan payments into an investment account, you might make enough to make a substantial dent in the balance on your loans with your investment profits.

Of course prepaying student loans or a mortgage will give some a feeling of accomplishment and mental relief. And if you feel such is the case for you, I by all means encourage you to do these things. It's important for you to do things with your money that make you feel strong from a financial standpoint - despite whether or not they make black-and-white economic sense. I just wanted to propose the idea of using leverage/debt to your advantage.

If anyone has any questions, please do not hesitate to ask them or post comments. Thanks for reading and until next time....

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