show
I’ve leaned on our primate cousins to explain debt before. Debt is a gorilla on your chest, stealing your bananas, etc. Enough monkey business. Today, we’re going to apply some real numbers for you to digest. What’s the actual cost of debt?
When you borrow money, you have to pay it back. This is the principle of the loan. But you also have to pay interest, a fee for the luxury of spending money you don’t really have. You probably already knew these things.
But there’s also the opportunity cost, which most folks don’t consider. By paying back debt, you’re missing opportunities to invest your money in different ways. Rather than putting $500 a month towards students loans, you could be putting that money in a 2% online savings account, or in a stock market index fund. We’re going to consider that today. The true cost of debt is the opportunity cost of the missed alternatives.
Disclaimer: there are obviously some huge benefits that can come from taking on debt. Perhaps it’s education, or a roof over your head. Debt enables utility that we might not otherwise get. This cannot be overstated, and represents the “other side of the coin” for the argument I present below. But, at least today, I’m only going to look at the negative side of the balance.
Most of us are familiar with at least one of the big four forms of debt: student loans, house mortgage, car loan, or credit card debt. So let’s roll up our sleeves and dig in.
Student Loans
Diana graduates with $50,000 in student loans at a 6% interest rate. Her loan servicer has given her 10 years to pay back the loan. A little spreadsheet math yields us a repayment of $548.45 per month. If Diana pays that amount for 120 months, she’ll be back to neutral. No more debt.
But what if Diana had no loan, and she invests or saves this money instead? This potential investment is the opportunity she’s missing. We’re going to use 2% returns to represent a typical online savings account, and 7% returns for an index fund.
While Diana borrowed $50,000, her 120 repayments total $65,814; this is the loan principal plus interest.
But the opportunities she missed are worth $72,357 in the safe savings account, or $90,986 in the riskier market index fund.
The “true cost” of the student loan (in this example) is about 1.4x ($72357/$50000) to 1.8x ($90986/$50000) higher than the amount borrowed.
Mortgage, Car Loan, Credit Card…
For the other debts, the math will stay the same but the inputs are different. What’s important to consider?
- The loan’s principal
- …interest rate
- …and term (i.e. time taken to repay)
- Opportunities—we’re going to stick with the 2% savings and 7% stock index
30 year mortgage
Let’s assume Kelly has a $200,000 mortgage borrowed at 4%. Most mortgages are 30 year terms. Her monthly payment will be $943.52, and her 360 payments will sum up to $339,667.
And those opportunities? The simple savings account would be worth $447,045, while the market index fund would be worth $1,000,284—yes, that’s over a million dollars. The “true cost” of the mortgage is between 2.5x and 5x higher than the amount borrowed.
But you can get a shorter mortgage, right? Let’s look at that…
15 year mortgage
Now Kelly is buying the same house for $200,000 at 4%, but is repaying the loan in 15 years. Her monthly payment will be $1467.42, totaling $264,134 of payments over 15 years.
The simple savings account would have been worth $302,939 (1.5x loan), and the market index fund would have been worth $433,317 (2.2x loan).
Compared to the student loans, the sheer length of the term is the important factor here. The longer that interest is working—whether against you (a loan) or for you (an investment)—the more impactful it is.
Car Loan
Ian is buying a new Subaru for $25,000. His local credit union is letting him borrow that money at a 3% interest rate for a 5-year term.
Over those 60 months, Ian will pay a total of $26,860. If he’d put those payments into the 2% savings account, he’d have $28,469. In the 7% market index fund, he’d have $31,810.
The car loan costs about 1.1x to 1.3x more than the original amount borrowed. Compared to the other loans here, that’s not too bad. This is due to the relatively short term and low interest rate in Ian’s scenario.
Credit Card Debt
Credit card have some of the highest interest rates around—this is why they’re a little bit scary. 18% is perfectly normal; yikes! And as of 2017, the average American was in a little more than $6000 of credit card debt (source: Experian). Different cards work different ways, but a typical repayment plan might say, “Pay back 3% or $150 per month, whichever is greater.” So that’s what we’ll use.
Our average American debtor, John, will need 56 months to pay back his $6000 debt, and he’ll pay a total of $8724. If instead he was able to put that money into a savings account, he’d have $9097. If in an index fund, he’d have $10,104. Even though his repayment window was less than 5 years, John’s credit card debt opportunity cost is 1.5x to 1.7x the amount he borrowed. That’s a steep price to pay!
Cost of Debt, summarized
The debt monkey doesn’t just steal money via loan interest. He takes away opportunities that you could’ve had. The debt monkey stole my dreams!
Ok, ok. Hopefully today’s math lesson showed you a couple important facts:
- The true cost of a loan is intrinsically tied to its term. The shorter the term, the lower the cost. Longer terms can lead to drastically higher costs!
- The loan interest rate, even on short loans, can significantly impact the cost. Just check our the 15-year mortgage vs. the credit card. Similar costs despite their starkly different rates and terms.
And that’s that. Next time you sign up for debt, use this idea to understand it’s true cost.
Thanks for reading the Best Interest.
Source: bestinterest.blog