Debt: Pay if off or Let it Ride?
Credit is an agreement where one party allows the purchase of a good (or service) without immediate repayment. The lender typically makes the agreement under the condition that the borrower repays the money plus interest over a given period. Debt is the amount that is owed.
High opportunity-cost professions are most commonly accessed using credit in the form of a student loan. This leaves the borrower indebted to the lender be that a bank, credit union, or a federal government.
Theoretically, all parties win. Aspiring CRNAs have the ability to pay tuition, which is a prerequisite to becoming a CRNA. Universities collect tuition to support their programs. The bank profitably lends money covering expenses and contributing to annual shareholder profits. But there must be balance.
To no surprise, the cost of tuition is high with many doctoral programs costing over $100,000. Over the past decade, tuition costs have been rising making many professions and expensive universities not a viable financial option. I get that it’s not all about money, but it’s no fun to pay $200,000 for degree that produces a $40,000 annual income.
A CRNA salary compensates for the cost, so it’s manageable at this point in time. If compensation decreases or tuition continues to rise exponentially, the situation will change. This post isn’t about rising education costs, so I’ll leave it here.
The lenders are the last variable. They have all kinds of formulas accounting for their cost to borrow, the amount per loan, and the default rates – among other things. The most relevant to this conversation is the lender’s cost to borrow from the Fed.
The Fed in 2 sentences:
The Federal Reserve System (the Fed) is the central bank of the United States. Responsibilities include managing monetary policy and setting interest rates.
These are the folks that control the interest rate the banks pay to accumulate the credit, which is loaned out to aspiring gas passers.
It’s likely not news that interest rates have been rising. Jerome Powell, chair of the Federal Reserve, is trying to curb inflation to the mythical 2%. It’s the long-term goal of the United States to stay between 2% and 4% for reasons not backed by any evidence from what I can tell. I think it’s just a reasonable range that is sustainable. Economists, please chime in!
Inflation in 2 sentences:
Inflation is good because it increases production and spending. Inflation is bad because it decreases purchasing power and increases interest rates.
If you leveraged a bunch of money with a fixed interest rate to buy 100 single family homes, you want massive inflation. Your debt will become worth less and the leveraged houses will increase in value, just like during COVID.
The rising tide lifts all boats – but to different degrees. If your cost of living inflates, but wages remain the same, it’s not that great. If you are in the A.I. boom, your software engineering job may have just tripled in compensation. Generally good for borrowers, bad for fixed income retirees who are losing buying power.
2008 Financial Crash
Since this market downturn, interest rates have been low and business have been spending like crazy. It’s easy to expand when it’s cheap to borrow money. Mortgage rates were low, so people were buying lots of house. And the stock market was returning 14% annually for over a decade. Lots of 401(k) millionaires were made during the 2010s. Times have changed.
Assets vs Liabilities
There are more formal definitions but use these for the sake of argument. Assets are things that have value. I’m in the Rich Dad Poor Dad boat and prefer to think of assets as items of value that also generate a return on investment. Equities, bonds, and rental properties to name a few.
Liabilities are debts. Things that don’t provide a return. Basically, just cost money. Think car and clothes. Some say vehicles are depreciating assets, I say liability.
Nothing wrong with liabilities. Sometimes they are like carbohydrates – good for the soul. Vacations are total financial liabilities, but essential for maintaining sanity.
There was a study done about “power lawyers.” The kind that represent extremely wealthy clients, major corporations, and work 100 hours per week. Researchers found that a 4-day hiatus once per quarter increased annual billables compared to working every day of the year. Apply as you will.
Grooming a Money Tree
I always thought Bonsai trees were a type of tree. Bonsai means growing and cultivating trees in small pots. I never undertook the endeavor because the initial treatment and manipulation of a tree requires 3 years of growth and care to manifest the results. It’s not a very action-packed hobby.
Unfortunately, money trees work the same way. At this point in my life, I have laid the groundwork for growing and cultivating money trees. Mrs. TFC and I each have a personal brokerage, 401(k), HSA, and IRA invested in a variety of equities and bonds.
Growing and Cultivating
Our money trees are our strongest assets. We water them monthly via monitoring and contributions. And continuous research leads to occasional pruning. We aspire for them to bear significant fruit and be quire valuable as the years pass.
Sounds great, but how are money trees relevant to this post?
Debt is commonplace. How to best balance paying off debt while trying to plant a money tree forest? I separate debt into 3 categories:
Low Interest Debt: 0-3%
Medium Interest Debt: 3-5%
High Interest Debt: >5%
The math nerds of the world claim that an investment providing a greater return than your debt necessitates holding the debt and paying the interest. Makes sense. If my mortgage is 3% and I can invest in a Certificate of Depression at 5%, why not hold onto the mortgage and pocket the 2% difference? Plus inflation will minimize the debt burden.
Grad PLUS loans at 7%? Well, that CD just doesn’t cut it. The stock market historically returns 9% annually, but that’s not a guarantee like your debt. The risk may not be worth it.
With interest rates on the rise, fixed income products are paying 4-5%. That makes holding low interest debt viable. Below 3%, it may be worth holding current debt. New debt has origination fees associated and may not be worth it. High interest debt is where folks start playing with fire because there are not many fixed income products today that meet the necessary returns.
Mathematically, retaining low or even medium interest debt is a compelling argument when speaking about fixed rates because it’s a guarantee. I make this approach well known to everyone involved in TFC financial coaching. I personally don’t object to holding low interest debt provided income that could pay off the debt is out there digging holes in the ground to plant money trees.
The most common example of holding debt involves an employer retirement match for W2 employees. Say your employer matches 3% of your 401(k) contribution. I always recommend taking the match prior to paying extra towards debt. It’s an instant 100% return, plus your contribution is tax advantaged.
I’m not saying max your retirement accounts if you are heavily in debt, but investing $6,000 to meet the employer match will pay off over the long term.
This is why I recommend tracking net worth monthly. Money is going multiple directions…living expenses, debt, payments, retirement, etc. The trends of less debt and growing investments will become clear if you track monthly. Mrs. TFC and I track all accounts monthly for this reason. It’s the 10,000-foot view.
Emotion
This is the trump card. It takes a special kind of cyborg to be immune to the emotional side of money. Personal debt is emotional baggage. Unfortunately, most people have carried debt their entire lives, especially those working in high opportunity cost areas.
This is important because I can’t begin to explain how good it feels to be debt free. To not owe a single sole any money. The feeling of freedom from the shackles of debt. It’s not worth holding onto debt if you can’t sleep at night. It’s just not worth pocketing the 2% difference.
If it bothers you to have a mortgage at 2.5%, then pay it off. My applause to you. I will NEVER fault anyone for paying off debt. Even debt at 0% for 12 months. It’s never a wrong move.
Ethically, the borrower promises to pay back the lender. It goes beyond math and truly becomes emotional. As with buying liabilities, sometimes it’s just worth it regardless of what the math says.
Debt
There are plenty of people who became rich using debt. All of the billionaires. Most startups use debt. A lot of it. Debt was really common over the past decade because rates to borrow were so low. Why not use it as a tool to expand?
That’s business. The Financial Cocktail is about personal finance. If you want to play with the big boys and leverage yourself to the moon, I suggest incorporating. That’s protection for when things go South.
Want something funny to read about leverage? Check out r/Wallstreetbets where regular people trade options, which is sort of like leveraged stock trading within a time frame.
Anyway, I acknowledge the necessity of debt. I acknowledge the fact that interest is necessary. And that interest must change based on the macroeconomics of the United States. There isn’t anything wrong with debt carefully acquired such as to get through school.
So what does all this come down to? If you want to pay off your low interest debt, I’ll be your biggest supporter. Want to push your luck and try to out earn your payments? Good luck. I’ll still root for you.
