Debt & the divergence of decisions

From a personal finance perspective, debt’s true interest rate isn’t just 3%.

Not only are there intangible prices to pay for assuming debt: opportunity cost, risk, cash flow, etc., but there are some very tangible costs that add up to your debt load.

It’s quite easy to take a loan, and assume that the cost of the debt is a flat 3% annually. Whether those numbers make sense or not is another discussion entirely. But what’s not often pondered is the question: what could I have done if this was cash?

Whether or not the cash exists isn’t a question. When you assume debt, you’re assuming the obligation to pay it. With cash. Usually that you make from some form of income.

So the question is: if I had kept all this income as cash, instead of paying off debt, what could I have done with it? The answer depends — it varies according to your situation, the amount, the year, your risk profile, your location — or really, an infinite amount of factors. If you took the simplest of approaches and threw it into the stock market, you could probably make 5% annually. If you invested it directly into rental properties, you could probably make closer to 9%. If you took a more hands-on approach and started a business with it, the number could be far greater.

The true cost of debt is the interest rate, plus the lost investment factor. Let’s say 5% to be conservative.

Let’s say that a new car costs $25,000. Right now, the average interest rate for a 60 month payment is 4.71%. If you were to take out a loan for this car, you’d pay a total of $28,108 over the next five years.

But what if you had kept that $25,000, and had it sitting ready to invest? Conservatively, you could have made $3,307. That means that, if you buy that $25k car with a loan, the hit to your net worth is actually $31,415.

We won’t even get into depreciation here. That’s not the question. Sometimes you just gotta have a car, and as you use things they go down in value. Such is life.

It may seem like a trivial amount. So debt costs an extra few thousand. So what?

But when you extrapolate it over your lifetime, it suddenly means very much. It means you take this hit every five years when you buy a car. It means you take this hit on a fantastically large number with every house mortgage. And if you assume credit card debt, currently ranging between 15-22% depending upon credit score, it starts wreaking havoc. 15-22%? It’s more like 20-27% when you consider lost investment factor.

9% on your car. 27% on your credit cards. 8% on your house. There’s almost no possible way that your investable money left over from servicing these debts will be able to beat those true interest rates.

Ever wondered why high-level incomes in Northern Europe are so low? Wondered why a corporate VP can make $80,000 in Germany or Scandinavia, where the equivalent position would easily pull in $250k in the US? Yet somehow, their lifestyle is as good or better than the US equivalent. Of course, there are many factors, but I think the primary reason is debt load.

That’s why sustainable budgets have more to do with accumulating wealth than actual income. (It’s always good to make more money, of course, but combine the two and you’ve got an unstoppable powerhouse).

Let’s break down two identical incomes, with different debt loads.

Say household Smith makes $100,000. They are 30 years old, have a mortgage (American average of $224,500), and a couple mid-level newer cars and other debts (totaling the American average of $90,460 in consumer debt). $4,900 of that consumer debt is on credit cards (American average).

After tax, this couple’s take-home is $72,029. That’s $6,002 per month.

They have some inflexible expenses. These bills include utilities ($171), car insurance ($260), health insurance ($50), gas ($250), phones ($134), internet ($60), and food ($1100). The essentials come to a total of $2,025 per month. This leaves $3,977 for the debt.

Their mortgage costs $1,061/mo. Their cars cost $937/mo. Their credit cards cost $139/mo. Their other debts (student loans, personal loans, etc) come to a total of $559/mo. This comes to a total of $2,696 dedicated towards servicing debts. This leaves a total leftover of $1,281.

A family making six figures — with only $1,281 left over. This $1,281 has to go towards entertainment, eating out, emergency expenses, vacations, and saving for retirement. Even if you decided to forego all the entertainment, is saving $1,281/mo or $15,372/yr enough for you to retire on?

The answer here isn’t to make more money. This family is 30 years old and already making higher than average.

When you look at this family’s choices, it’s pretty reasonable to expect that their debt will scale along with their income, after all. If this family’s income goes from $100k to $200k, they’ll likely move into a nicer house and get a Lexus instead of a Toyota.

And they’ll still have $1,281/mo left over for entertainment and retirement.

In the end it usually works out. But this family will definitely not retire early, and will definitely not be wealthy upon retirement. They will be average, because average choices result in average outcomes.

Let’s look at household Jones.

Same income. But they’ve made some slightly different choices. They always pay cash. They drive used cars. They rent a lower-cost house (average of $1200/mo). They never assumed credit card debt. They still have the same bills, except their car insurance is cheaper (50% of new car cost). Their total expenses are $3,095, including rent, and no debt. This leaves $2,907/mo or $34,884/yr that can go towards entertainment and savings.

And the thing is: if their income increases, household Jones won’t scale their lifestyle as fast as household Smith. So when household Jones starts making $200k, they suddenly have $106,943/yr left over.

If they maintain their current lifestyle for three more years, they can buy a house outright.

And it doesn’t stop there. At that point, after they put a quarter million of their net worth into a house, they now have no rent or mortgage to pay. Add another $1000+ in savings…each month.

It still might not seem like a lot.

Who cares? If it works, it works, right?

Mortgages and car payments “work” for lots of folks.

But over the course of ten years, with the same income, household Smith will be living paycheck to paycheck, while household Jones will be millionaires.

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