Today at our day job, Peter and I were discussing personal finance. A senior colleague of ours caught part of the conversation and said, “Is Peter telling you about getting rid of debt? I told him! Debt free, that’s for me!” He then asked me, “Are you debt free?” I told him I was not and he questioned why I invest in that case. I said to him, “Is debt really all that bad? My highest interest rate is 4.00% and if I can’t make a better return than that, then I have no business investing.” The conversation didn’t continue, but I think our colleague’s view represents prevailing personal finance wisdom. Debt is bad, savings is good, and you shouldn’t invest until you have those pre-requisites in place.
I have to respectfully disagree with that point of view as an absolute rule. Don’t get me wrong. There is definitely bad debt in people’s lives that should be a priority in most cases. As of the time of this writing, the average credit card interest rate is between 13 and 16 percent. Paying off debt like that is an instant 13 to 16 percent return on investment. However, if you’ve managed your finances well and the debt you carry is low interest, then is paying it off really that smart? If you learned about various investment vehicles, do you think you could do better than 4% annually? I would argue the answer is yes.
I was raised with a fear of debt. My mother always told me that you should never get a car loan and that it was better to drive a lousy car than incur a monthly payment with financing. I learned the hard way that this advice wasn’t very good. A couple years ago, after sinking thousands of dollars into my 1999 Cadillac Eldorado, the vehicle finally died. Before it died, I made a critical mistake in not having emergency savings on hand. As a result, I was forced to liquidate my holdings in Facebook stock. With the benefit of hindsight, I now realize that I missed several thousand dollars in profit because of that one stupid mistake.
By continuing to dump capital into a car that was dying, I made a second mistake by not opening myself to the idea that debt isn’t so bad. My debt payments on an auto loan would have been negligible compared to how much money I could have made selling my Facebook shares at a better time. After reflecting on that experience, I finally wised up. I bought a used Honda Accord, which is very low maintenance, with 4% financing over four years. The consumer credit card debt I accumulated because of my now deceased Cadillac was transferred to a 0% credit card with 18 month terms. I took the amount I transferred, divided by 18, and that was the amount that I set as my automatic payment to the card. I did this instead of further depleting what little savings I had and I never paid a dime of interest on that borrowed money.
When considering debt, think about it from a cash flow perspective. Sometimes keeping money in your pocket is smarter than emptying your wallet to pay off debt. Making that decision hinges on your ability to use your financial education to evaluate your options. In the time since my vehicle fiasco, I prioritized a portion of my cash flow (read: income from a paycheck) to savings. With time, this nest egg has grown and I feel more confident now that I can handle unexpected issues that may arise. With that confidence, I’ve been able to pursue investment opportunities that will increase my cash flow.
People instinctively know this debt principle when they consider their mortgage or their student loans. Low interest, fixed rate debt can help you gain leverage in situations where paying the full amount is difficult or impossible. That doesn’t mean that you can’t still make a lousy deal. If you finance an expensive McMansion that you can’t really afford or you take out an obscene amount of student loans to pursue a degree that won’t translate into a commensurate income, then you can bet your bottom dollar that this debt is very bad. However, if you use debt with purpose and with the idea of “deal structure” in mind then you can accomplish things that wouldn’t be economically feasible any other way.
Businessmen, hedge fund managers, real estate investors, and others like them use this concept all the time. The difference with average people is that they don’t approach their personal finances and investing as if it’s a business deal. They view it as a chore or something that has to be dealt with. I propose that you need to become your own personal Donald Trump and start thinking about every economic decision you make as a “deal”. Some deals are good, some deals are bad, and some bad deals can be transformed into something good by using your creativity.
Being debt free is great, but at what expense are you willing to have that? Take a look at the balance sheet of any publicly traded company and you will see massive amounts of debt. It doesn’t mean that the company is unsuccessful. Cash flow is the life blood of most companies and it plays the same role in your life as well. Start viewing your personal finance in a deeper way and with overall cash flow in mind.
Action Steps
- Create a personal cash flow statement that includes money going in and money going out
- Determine what interest rates you’re paying on your debt
- Consider ways that you can lessen your debt service payments every month, while still paying down the principal.
- Set goals for what you want your debt situation to look like in a year, as well as what levels you want your positive cash flow and cash reserves to be at.
- Try to renegotiate or restructure the bad deals you are currently in while continuously looking for opportunities to increase your cash flow. Consider this simple example. If you financed a $500 gumball machine at 10% annual interest you would pay $50 interest in the first year. If that same gumball machine made you $10 a month, then your annual revenue would be $120. Revenue exceeds debt obligations, making this a very good deal.
Leave a Reply