In Defense Of The Debt Monster, Get It Before It's Gone
Be honest, just by the title, I’ve already alienated half my audience. Particularly in this part of the country, where conservative values and Dave Ramsey reign supreme; a “pro” personal debt article is going to cause some controversy. But before you reach for the pitch forks and lobby to have my CFP® revoked; just hear me out.
Credit Card Debt
It’s no secret that Americans are loaded down with debt, particularly of the credit card and student loan variety. And I am here to tell you if you have credit card debt, stop reading this article right now, go get a job and PAY THAT OFF. NOW! Do not pass go, do not save for emergencies, do not eat, do not sleep until you’ve paid that off. Deal?
Now, on to student debt. According to the US Department of Education, the amount of outstanding student loan debt has increased to $1.1 Trillion in 2014 from $516 Billion in 2007. And it’s no surprise in the wake of the great recession, deflationary pressures, high interest rates, and lack of wage growth; our graduates are struggling to make even the minimum payments. In fact, 51% of borrowers are in default, forbearance or deferment. Banks won’t refinance them, the student loan interest income tax deduction hurdle is too low, and graduates cannot afford to put off saving for retirement**.
But, while we wait patiently for legislation to address these pressures; the rest of us have got to get serious about our debt strategies. I’m sure you’ve heard the words “interest rates are at historic lows” once or twice in the last five years. But it seems we may finally begin to see rates begin to creep up in 2015. The Federal Reserve has ended its asset purchase program and pledged to be “patient” in raising the target fed funds rate, which most believe to mean late summer. All these complex economic policies simply mean that the interest rate environment has been GREAT for borrows and BAD for savers. But the tide is turning!
Access to credit is truly what drives housing, consumer spending, and our economy. Can you imagine how long it would take you to save enough money to pay cash for your house? In developing countries I work in, this access simply does not exist. Building a house takes years since as you save for materials, you must literally build brick by brick as you can afford to purchase them. Otherwise, predatory lenders will lend to you at a rate of 35% APY. But this is America, where a single 20-something can walk into any bank on any corner and be granted a mortgage loan at interest rates below 5%. And not only that, that same 20-something can deduct the interest payment against her income taxes, build equity and collateral in her house, and completely avoid capital gains tax when the time comes to sell it. God Bless America. Stop being afraid of mortgage debt friends, and don’t get in a hurry to pay it off as long as better savings and investment options exist.
That brings me to the topic of leverage, a term that unfairly got a negative connotation during the crisis. Instead of always viewing interest as a burden of payment, what if we, as savvy prudent investors, were able to recognize opportunities to borrow at one rate, and turn around and invest for greater growth? I’ll give you an example: let’s say an auto dealer offers you a five year, 2.75% interest rate on a $20,000 car. You could always pay cash and avoid paying $1,297 in interest or, alternatively you could have invested that $20,000 in an indexed S&P 500 ETF which has averaged 15% over the last 5 years. At the end the day (interest inclusive) you earned $10,699.68. There was certainly risk involved in the transaction, and it’s not realistic to believe you’d earn 15% every year in every time period, but what I’m trying to illustrate is when someone offers you financing at levels well below 5%, and you have the means and expertise to leverage your investment, you should not be afraid to do so. Successful investors are able to recognize these opportunities, and do so constantly and intuitively.
Equity vs. Fixed Income
Lastly, I would encourage you not to be afraid to invest a portion of your portfolio in the equity markets even if you have very low risk tolerance. Gone are the days where a retirement portfolio could be invested in 7% risk-free government bonds. 10-year US Treasury bonds are today yielding a meager 2%; and when you take into consideration that bond interest is fully taxable at ordinary income rates, inflation, and fees you are suffering a significant negative real return. Equity markets offer favorable tax rates on both long-term capital gains and dividends. The diversified S&P 500 index dividend yield is above 2%, for which most investors pay only 15% tax with the likelihood of growth to keep up with inflation. With Americans living longer and the costs of healthcare rising, the current environment is forcing savers to adopt a more globally diversified portfolio of stocks and bonds to retain purchasing power in their retirement portfolios.
Never forget that personal finance is exactly that, personal. Every person and every scenario is different. Will you succeed by diligently reducing your debt and aggressively saving cash? Probably. I wish more Americans would adopt this mindset. But for those who are lucky enough to still be in your prime income earning years and truly want to be good stewards and prudent investors, I would urge you to consider taking on more cheap debt and equity exposure. Interest rates are truly at historic lows, and the landscape is prime to take advantage before it’s too late.
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**For those struggling with the burden of student loans, don’t lose heart. First, make sure you’re contributing the maximum amount to your 401(k) that your employer will match, then that you’re making an annual Roth IRA account contribution (max $5,500/per year). After that, get those loans prioritized by interest rate and continue to stay current. Depending on the interest rate and ability to deduct your interest payments; it may or may not make sense to aggressively pay them down before investing in other taxable accounts or ventures.