I can’t start a post about debt, without aknowledging my huge debt to Daraius at million mile secrets.
By lending me his well attended stage, with his interview yesterday, my page views exploded by a factor of about 50.
Thank you, Daraius.
But the show must go on…
If investing exposes the miracle of compound interest, then indebtedness exposes the hell of compound poverty.
They are, quite simply, two sides of the same coin.
With investment, small percentages become large sums as your dollars make dollars, and then the dollars that your dollars made, make more dollars.
This results in exponential growth which is a powerful thing indeed.
But owing money, and paying interest, means that the money that you pay is money that you lose, and the money that you haven’t paid yet continues to pull you farther in the direction of debt because of it’s compounding interest. It’s like running in quicksand. There’s nowhere to go but down.
Fun with Debt
So if you have debt,and are interested in pursuing early retirement, the obvious first step is to start paying down your debt.
But in what order should you pay down the debt?
I still have plenty of student loan, and mortgage debt. But fortunately I don’t have any more of the worst kinds of debt such as credit card debt, or car debt,
If you are thinking about paying down your debt, you might consider a strategy such as this:
1. Eliminate high interest debt first. For the most part this means credit card debt. Credit card rates are so criminal that carrying a balance on a credit card is almost always a huge mistake.* (Even for the sake of my beloved miles game.)
2. Eliminate a variable interest rate debt next. All things being equal, you are taking on tremendous risk by carrying variable-rate debt. Interest rates might stay low for a long time, or they might not, nobody knows. But having a significant amount of money in variable rate loans means that you are at high risk of losing a lot should interest rates spike. Why take this risk?
3. Eliminate all fixed interest debt by paying off higher interest rate loans first. (So if your car loan debt is at 3%, and your student loan debt is at 4% pay your student loan debt off first before making early payments on your Car loans)**
4. Pay off home mortgage debt last. The reason for this is simple: the home mortgage interest deduction. This deduction means that you pay for mortgage interest with pretax dollars. The higher your tax rate, the bigger a deal this becomes.
The home mortgage interest deduction is an interesting entity.
Because it saves money on taxes, it is often used as justification to buy a more expensive house.
To me this makes no sense. The only money you save on taxes is in the form of interest that you have to pay to the bank.
So in a sense, it is debt for sale. It creates cheaper debt. And I’d rather have cheap debt than expensive debt.
But you know what I’d rather have than cheap debt? You guessed it, no debt at all.
One thing about cheap debt though, is that if it’s cheap enough, you might consider paying it off a little slower and investing your savings in your retirement, instead of prepaying your mortgage.
This makes sense if your expected return on investment is higher than the interest you’re paying (after tax deductions) on your home debt.
What I’ve chosen to do with my mortgage is to pay it off at a rate such that the mortgage is entirely gone by the time I intend to reach financial independence. This way my expenses will plummet at the exact moment that I can safely consider retirement.
But realistically, no time is too soon to be living debt-free.
After all we’re talking about freedom. And freedom from debt is a lovely, lovely thing.
(Artist’s rendition of a life without debt.)
* You can find some credit cards with 0% interest balance transfer offers that can buy you some time, but that’s a game with real risks. Watch out for balance transfer fees.
** Make sure to take into account taxes. A tax deductible student loan at 4% may be cheaper than 3% car loan in some instances.
