Tuesday, February 1, 2011

Thoughts on Debt

If you haven't seen this clip, you have to. Sorry about the 7 second commercial.

(To be explicit, my loose definition of "affordability" is purchasable with cash...only with the exception of a home and a reasonably priced education).

So I haven't really blogged about personal finance stuff in a while, because there's not really much to say on the subject (just like the video clip says). Spending less than you make means that you'll save. Spending far less than you make means that you'll save more. Routinely investing savings over time will grow your savings. Routinely investing your savings over time in tax sheltered accounts will grow your savings even more.

Here's my personal finance observation of the year: If you have any debt at all, each discretionary purchase you make is essentially being financed at your outstanding debt's highest interest rate. Let me explain with a crude example.  I call it the parable of the candybar.

Let's say that I have an outstanding car loan of $10,000 at an interest rate of 10%, with 7 years left on the loan. Let's also say that I find a $1 bill on the ground.  Let's say I really want to buy a $1 candy bar.

What is the cost of a $1 candy bar?

If I am paying with cash, the cost of a $1 candy bar should be $1....right?

Am I really paying with cash for a $1 candybar?  I mean, I have a $1 bill in my hand, so it seems like this is the answer, right?

I'd disagree.  I think that any dollar that passes through my hands is a dollar that could have been diverted to repay my outstanding debt.  In other words, every time I spend money on something other than repaying my loan, I am essentially financing the purchase though my existing debt, with associated rates.  After crunching some numbers in Excel (=PMT(0.1,7,1)), this candy bar is really costing me $0.21/year for 7 years.

Does this sound ridiculous to you?  Financing a candy bar over 7 years?  Well this is precisely what we do when we fail to divert cash to accelerate repayment of loans!

It's the truth.  I'm a numbers guy.  I cut through the crap of the world, and I see things numerically.  Every time an indebted person spends any "discretionary" dollar, they are essentially financing these purchases through their existing loans.

If you take this logic even further, which I do, it extends to those not in debt.  A $1 candybar today, for a person with no debt, costs them the opportunity cost of investing that money for the rest of their life.  When I blow $1 today, in my mind I realize that I'm forgoing $3.42 30 years from now for myself, my posterity, or a philanthropic organization (assumes a 4% real return, which ought to be fairly realistic =FV(0.04,30,0,1), or alternatively, 1*(1.04^30)).  Alternatively, if I wanted an annual income rather than a distant payoff, a $1 candybar is costing me 4 pennies a year FOREVER in an opportunity cost.

You may think that I'm arguing about pennies here.  I'm not.  When you aggregate lots of these candybars, these hypothetical $0.04 annual dividends (if I don't want a distant payoff) or alternatively $3.42 30 years from now can amount to a fortune.

When you think even harder about the numbers, there is an even more compelling reason to get out of debt:  You don't pay taxes on savings.  When I go to the store with a $1 coupon, the impact on my net worth is an increase of $1 relative to the no-coupon scenario.  When I go to work and earn $1, I pay taxes on it, and I take home $1*(1-my marginal tax rate).  What does this have to do with debt?  When I put money in a bank account and earn $10 interest/year, my net benefit is $10*(1-my marginal tax rate).  However, when I save $10 interest, my net benefit is $10.  I don't pay taxes on savings.  If you were to ask me whether it's better to save 7%/year in interest payments by repaying debt or diverting that money to a risk-free, taxable investment of 7%/year, the obvious answer would be to repay debt because there is the obvious tax benefit.  I'd also punch you in the face because there is no such thing as a 7%/year return on investment for a riskless asset.

If you don't know what your marginal tax rate, you should.  It's the most relevant of all numbers in the tax system.  It is the tax rate on the last dollar you earn in a year, given that we pay taxes according to annual income.  Raise it high enough and there is an awfully compelling argument to under-employ by working part time.

Believe me.  I'm a numbers guy.  This is truth.  Get out of debt.  View every unnecessary transaction (aside from basics such as cheap rent, water, electricity, cheap groceries) as a renewal of your debt because you are consciously deciding not to repay your debt.  There is such a mathematical, emotional, and financial purity to my argument.  We are living in the richest period in the history of the earth.  We have so many resources at our disposal that we've turned money-dumb.  Beat the system.  Realize that you can live just as happily on much less, provided that you use your frugal dollars wisely.  Over time, you will watch your savings grow.  This is as fulfilling as anything to me, knowing that growing savings equates to financial security for my family and an increased ability to do good in the world.

Life is too short and there are too many needs in the world to mindlessly squander cash...especially while being subject to the bondage of debt.

Never be complacent by paying the minimum amount with an outstanding debt.  It's this complacency which keeps people from realizing how truly indebted they are.  I think being suggested to finance things such as furniture, electronics, and even vehicles is insulting to my intelligence.  Being offered to finance something other than a home is analogous to a sales guy implying to me that I don't understand the basics of mathematics, and that I don't have the self-discipline enough to restrain my spending enough to buy a couple hundred dollar sofa while living in the richest country in the history of the world.  Give me a break.

“The most powerful force in the universe is compound interest.” Albert Einstein (maybe)
“One of the most potentially destructive forces in the universe is compound interest against you.” Me
"Those who don't understand interest pay it, those who understand it make it."  unknown source