Managing Debt

Most folks have some sort of debt.  There is “good debt” and there is “bad debt”.  Good debt is normally associated with debt that is taken on to invest in some sort of asset that generates income and/or increase in value/worth in excess of the debt load.  For example, if you purchase a rental property with debt and that rental property generates positive cash flow, it is considered good debt.  Conversely, if you have credit card debt that is costing 18% interest, it would be considered bad debt.

So what do you do if you have debt?  Do you focus on paying off/reducing the debt or do you focus on growing your asset base?  I think the following rule of thumb is useful.  If the debt is some sort of bad debt that is not tied to any investment in an asset and the interest is over 8%, then you need to get rid of that debt or refinance the terms.  When you invest, you can certainly generate larger returns than 8%, but the higher the return you shoot for, the larger risk you are taking.  Think about the tax consequences of the money you make from a job.  This money is first taxed at the federal and state levels (and don’t forget social security/medicare taxes) and then you can make the payments on the debt.  That means for every dollar of interest payment of bad debt, you have to earn about $1.50 of income to pay that interest.  So, even 8% interest is like 12% interest equivalent.  Now the likelihood that you can outperform 12% return on an investment with a high probability of consistent success is low and gets much lower as that debt load goes higher.

For these types of bad debt, I look at two factors.  The first is the interest rate.  Usually, the highest interest rate should be tackled first.  Notice I used the word tackled instead of paid off.  If you can refinance that with a lower rate, than do that first.  The next item to look at is the monthly payment amount divided by the payoff.  I call this my cash flow return on investment.  This is especially important when you have a chunk of cash to pay off a debt.  Sometimes it is better to pay off a lower interest rate than the higher interest rate. Let me explain.  Let’s say you have a car loan at 6% and a boat loan at 8% and you have $4000 available for deployment.  The car loan has 12 payments left and the boat loan is another 18 years.  Clearly, the interest rate is lower on the car loan, but you have enough money to payoff the car loan, but not the boat loan.  So if you put down the money on the boat loan, you will get your $4000 reduction of debt on the boat loan and you will effectively be getting an 8% return on your investment in reduced interest on your principle.  However, your payment is unchanged next month because you are on a fixed payment plan. What you’ve done is shorten the length of time you will be making those payments.  If you instead paid off the car loan, you would be saving about $350 in cash outflow the following month.  So even if the interest rate was higher in the boat loan, I would have chosen to pay off the car loan in this instance.  You need to understand cash flow to retire early. By paying off that car loan, you not only received a 6% return on your investment, you received a $350/$4000 = 8.75% monthly increase in your cash flow by making this investment (that is over a 100% annualized return).  For “only” $4000, you have enabled yourself to have $350 more per month.  Yes, you would have achieved this situation in any case in 12 months, but this enables you to put that extra available $350 next month to help pay down other debts faster or make investments into some asset.