Author Topic: pros and cons of low interest debt  (Read 5475 times)

Hedge_87

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pros and cons of low interest debt
« on: July 05, 2014, 01:05:40 PM »
     So I was happily cruising along reading a few treads here on the forum and eating my ham sandwich i just made for lunch when all of a sudden I stumbled across a post by arebelspy stating that paying off low interest debt might not be the best decision from a mathematical standpoint. I've always firmly been in the debt=bad camp and so I possibly overlooked using debt as a tool. I'm recently Married and my wife has quite a bit of sl debt that I have been obsessing about knocking out as soon as we can. However the interest rates on most of the loans are ~2.75%.
      By the numbers it really doesn't make much since to pay this off since I can technically invest my monthly income that doesn't go to expenses and come out ahead most of the time. Not to mention you get a tax deduction. Then you can factor in inflation and your minimum payment becomes less of a % of your expenses every year. I feel like we both have fairly secure jobs and live far below our means so I am really considering not paying of these loans any faster than I have to and investing the difference.
      So if I can make money this way and the interest rate is below inflation rates then how does the bank make any money on these loans? Please excuse my ignorance up until about 2 year ago I just maxed out my 401k and A roth IRA and put the added excess in my savings account. this is how I found MMM I didn't know what else to do with the rest of my money lol (first world problem I know).
     

apfroggy0408

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Re: pros and cons of low interest debt
« Reply #1 on: July 05, 2014, 01:22:09 PM »
This is a common question throughout the boards and one I battle with myself.

You have a guaranteed return of whatever your interest rate is by paying it off, guaranteed.

You incur the risk of potential loss of future earnings based off the typical market return throughout the years.

It seems the most common advice here is anything below 4% invest, anything above 6% pay off, and in between it's a toss up.

Since finding MMM I've taken out 4 student loans that were all above 5.5% and I have 2 remaining one at 4.5% and the other at 3.4%. Personally I'd rather just pay off the loans and start investing once I'm debt free!

But it's a personal choice based on comfort level.

CDP45

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Re: pros and cons of low interest debt
« Reply #2 on: July 05, 2014, 01:27:22 PM »
The problem with student loan debt is there isn't an asset you can liquidate to retire it. Plus it wasn't invested in an asset that has any sort of income now. The money went to the school, and because there isn't much correlation with higher tuition school and income later in life (especially for females), it's kind of a bummer deal.

And it sucks having it at the beginning of working too, but it almost sucks more to use a big chunk of savings to pay it off. I'd say if you're not saving up for a down payment, pay it off.

frugaliknowit

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Re: pros and cons of low interest debt
« Reply #3 on: July 05, 2014, 02:09:19 PM »
You need to compare "apples to apples".  Paying off student loan debt is the equivalent to a risk free return of the after tax interest rate you are paying on the loan.  If the after tax interest rate on the loan is 2.50%, paying down the loan is the equivalent of a risk free return of 2.50%.  Where can you get that, my friend?  You might think of it as the "bond portion" of you asset allocation.

Yes, if you invest the equivalent in an index fund, depending on the time period, you will most likely achieve better returns, however the risk is different and not comparable.

Hedge_87

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Re: pros and cons of low interest debt
« Reply #4 on: July 05, 2014, 02:21:16 PM »
You need to compare "apples to apples".  Paying off student loan debt is the equivalent to a risk free return of the after tax interest rate you are paying on the loan.  If the after tax interest rate on the loan is 2.50%, paying down the loan is the equivalent of a risk free return of 2.50%.  Where can you get that, my friend?  You might think of it as the "bond portion" of you asset allocation.

Yes, if you invest the equivalent in an index fund, depending on the time period, you will most likely achieve better returns, however the risk is different and not comparable.
What about maxing out her tax advantaged accounts (this is her first year with a big girl job) then pay off loans instead of investing in taxable accounts?

bacchi

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Re: pros and cons of low interest debt
« Reply #5 on: July 05, 2014, 02:37:56 PM »
If the after tax interest rate on the loan is 2.50%, paying down the loan is the equivalent of a risk free return of 2.50%.  Where can you get that, my friend?

A 10 year treasury?

brewer12345

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Re: pros and cons of low interest debt
« Reply #6 on: July 05, 2014, 02:39:56 PM »
The choice of pay off debt vs. invest is not just about the math - there is a significant risk tolerance/sleep at night factor as well.  There are some people who do not have any interest in keeping any debt outstanding, regardless of what the math says.  Do some navel-gazing: are you one of them?

I am fairly risk tolerant when I can afford to be.  Throughout the accumulation period I was willing to pile up assets and leave low rate, fixed rate debt outstanding.  I was able to juice my returns based on the difference between what I paid and what I earned, and I was able to play tax games (max 401k, etc.) more easily.  When I was preparing to ER, I intentionally refi'd from an ARM to a 30 year fixed mortgage when rates dropped to my target.  The forever term of the mortgage means that payments are pretty modest and if we get into a nasty inflationary spiral I have a built-in hedge.

boarder42

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Re: pros and cons of low interest debt
« Reply #7 on: July 05, 2014, 03:05:40 PM »
not ALL debt is bad debt.  for most people its much easier to tell them debt is  bad so they dont put their money there and pay it off quickly..  my mortgage rate is 3% ... i read the thread with 2.75%(insanely good rate)  ... There is 0 reason to pay this off quickly.  mine at 3% is actually under avg inflation rates around 3.2 give or take.  so paying down a debt under inflation is burning money...   the rule of thumb most here follow is 5% ...over 5 pay it off.. 5% your choice... under 5% is a waste as the market avg's 6% on the lower end if you take out inflation.... which if you take that out of the 5% gives you a 4% difference in opportunity cost of your dollars. 

simply... you have a 100 dollar loan at a 3% interest rate.   you pay 3 bucks a year... you have 100 dollars invested at 6% you make 6 dollars a year..   when you add in inflation you actually make closer to 9-10$  a year over time... so you are making 6% more on your money by investing.  and we havent even brought in tax breaks yet.  paying interest on your loan or putting that money in a tax favorable account of some kind. 

but like others have stated this involves how comfy you are with risk b/c having any debt is riskier than having no debt...

Hedge_87

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Re: pros and cons of low interest debt
« Reply #8 on: July 05, 2014, 08:12:01 PM »
Quote
but like others have stated this involves how comfy you are with risk b/c having any debt is riskier than having no debt...

This is where I am hung up right now. I've been programed to see debt = bad no matter what the math says. I'm open minded and I feel like right now we could take on a little risk. My next question is (without going into some crazy pencil pushing moving money around on paper explanation) how do banks and loaning institutes make any money loaning at below inflation rates? Apologize for my ignorance.

brewer12345

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Re: pros and cons of low interest debt
« Reply #9 on: July 05, 2014, 09:39:28 PM »
how do banks and loaning institutes make any money loaning at below inflation rates? Apologize for my ignorance.

I wasted spent 5 years as a bank examiner, so I will attempt a simple explanation.  Banks don't care what the inflation rate is.  They are what is known as "spread lenders."  They borrow at X% and lend at X+Y%, typically leveraging their balance sheet something like 10 times or more.  If I can borrow at 1% and lend at 4% with assets:equity of 10:1, I have an in-built yield of close to 30% on my equity.  Who cares if inflation is 5%?

Real life is considerably more complicated, but that is the basic thrust of a traditional bank business model.

Hedge_87

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Re: pros and cons of low interest debt
« Reply #10 on: July 05, 2014, 10:41:53 PM »
I think I will stick to installing, troubleshooting, and maintaining electric equipment throughout the power and distribution industry its a lot simpler. so they are basically doing the same thing we are talking about with leaving student loans at 2.5% and invest and making hopefully more than that. the difference is (minus defaulted loans) they know they are going to hit their percent of interest. Am I in the ball park?

Nords

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Re: pros and cons of low interest debt
« Reply #11 on: July 05, 2014, 10:52:05 PM »
My next question is (without going into some crazy pencil pushing moving money around on paper explanation) how do banks and loaning institutes make any money loaning at below inflation rates? Apologize for my ignorance.
If these 2.5% loans were taken out during the last five years then their interest rate is probably higher than the rate of inflation at the time the money was loaned out.

Over 30 years, sure, the bank could hypothetically lose money when inflation rises above 2.5%.  But as Brewer says, the bank has already made its money during the origination of the loan and then by selling it to some other financial institution... which has probably borrowed cheap money from their government to buy the loan.  Someone may eventually get stuck with the hot potato and take a loss but otherwise it's a very liquid market.

I'd like to see the statistics on how long a low-interest 30-year mortgage (or cheap student debt) is really held.  I suspect that a surprisingly high number of Americans are of the same "debt=bad" mindset and are paying off their cheap mortgages as quickly as possible.  I'm planning on paying our mortgages (a personal residence and a rental) until I'm 80 years old... and I know there are posters on this forum who will let the govt forgive their student loans before they pay them off.

deborah

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Re: pros and cons of low interest debt
« Reply #12 on: July 05, 2014, 11:10:10 PM »
Look at it this way. I am currently looking at cars, and last month many dealers had 1% loans for 3 years. I am in Australia, and interest rates are a lot different here than they are in the US. 1% is amazing! I can get 3.75% on my money at my bank - I could get more if I put it in a term deposit for 3 years. So I could buy a car for $20,000 and hand over the cash. I could also buy a car for $20,000 and take out a loan and put my $20,000 in the bank (in a term deposit for the three years), and earn 2.75% (3.75 - 1) interest on the $20,000 for 3 years - so I would have an extra $1650 just by taking out the loan rather than paying in full!

Of course, this assumes that buying a car is a good thing to do, which is an entirely different discussion! Most MMMs would consider it $20,000 down the drain.

Note: this isn't really right, because I have left out monthly payments, simplified the interest calculations, assumed no extra charges on the loan etc.

brewer12345

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Re: pros and cons of low interest debt
« Reply #13 on: July 06, 2014, 09:24:04 AM »
I think I will stick to installing, troubleshooting, and maintaining electric equipment throughout the power and distribution industry its a lot simpler. so they are basically doing the same thing we are talking about with leaving student loans at 2.5% and invest and making hopefully more than that. the difference is (minus defaulted loans) they know they are going to hit their percent of interest. Am I in the ball park?

Like I said, real life is a lot more complicated.  That said, yes, you have the right idea.

Hedge_87

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Re: pros and cons of low interest debt
« Reply #14 on: July 06, 2014, 09:39:49 AM »
OK I think I get the general idea. Thanks for the explanations everybody. 

GGNoob

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Re: pros and cons of low interest debt
« Reply #15 on: July 06, 2014, 12:01:22 PM »
I don't mind debt and do not get emotional and feel like I need to pay it off right away. It's a numbers game for me. If I feel I can get a better return investing, I'll do that. I'm also happy to rack up debt on my 0% credit cards to invest. I'll pay it off before the interest kicks in.

I also look at it this way...we don't have a large emergency fund built up yet. If some emergency came up, which is going to help me more...putting away money for a rainy day or paying off that student loan?

sly

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Re: pros and cons of low interest debt
« Reply #16 on: July 06, 2014, 12:42:14 PM »
pro: higher potential return
con: higher risk

that's relly all you need to know about low interest debt, and that's why there is no yes/no answer to this question. Either you grow you balance sheet by taking on leverage and risk, or you don't.

Hedge_87

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Re: pros and cons of low interest debt
« Reply #17 on: July 06, 2014, 01:45:47 PM »
Quote
I also look at it this way...we don't have a large emergency fund built up yet. If some emergency came up, which is going to help me more...putting away money for a rainy day or paying off that student loan?

I get where you are coming at. We have six months of expenses in cash plus we are dual income and we are shooting for by the end of the year living on the smaller paycheck of the two (very close right now by my bar napkin math we may already be there).  Maybe it's just so ingrained in my brain from my childhood.  Debt=bad, very liquid assets like cash = good.  Thsee are not bad values to have but are not the best for long term wealth building I think.

GGNoob

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Re: pros and cons of low interest debt
« Reply #18 on: July 06, 2014, 02:15:59 PM »
Quote
I also look at it this way...we don't have a large emergency fund built up yet. If some emergency came up, which is going to help me more...putting away money for a rainy day or paying off that student loan?

I get where you are coming at. We have six months of expenses in cash plus we are dual income and we are shooting for by the end of the year living on the smaller paycheck of the two (very close right now by my bar napkin math we may already be there).  Maybe it's just so ingrained in my brain from my childhood.  Debt=bad, very liquid assets like cash = good.  Thsee are not bad values to have but are not the best for long term wealth building I think.

This brings up another potential area where you could increase your earnings. To me, keeping cash is just losing money due to inflation. With 6 months of an emergency fund built up, you may consider investing it (or maybe most of it while keeping 1-2 months in cash).

Here's a good article: https://www.betterment.com/blog/2013/08/06/safety-net-funds-why-traditional-advice-is-wrong/

I'm a big fan of Betterment and the taxable accounts are very liquid and it's very quick to deposit and withdraw funds. Just something to think about.

Hedge_87

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Re: pros and cons of low interest debt
« Reply #19 on: July 06, 2014, 02:31:40 PM »
Logant1337 you bring up a really good point.  I've had a very laissez-faire approach to personal finance up until now. That's why I am asking the stupid questions now lol. When we where one income (DW still a full time student) I felt this was very much needed. Even though I feel very secure in my career you just never know. Problem is I tend to procrastinate but I'll explain that later. Thanks for that article though.