Monday, April 17, 2017

Wealth: Debt Optimization

Living with debt can be hard. No, really. Ever hear Dave Ramsey’s show? Hear his guest’s “debt-free screams” when they come on the show to publicly announce that they have eliminated all of their debt? Crushing all of your debt is a big deal and it’s not an unreasonable thing to do when you’ve annihilated a lot of debt. However, one thing that I feel gets missed in all the hustle bustle about identifying and paying down debt is that sometimes investing in other items can be more beneficial than paying down your debt. Please allow me to explain.

Everyone knows that debt is huge in the USA but just how huge? In 2015, studies conducted found that the average American has $15,609 in credit card debt. That’s not including student loans, car loans, home loans, or other much larger loans that are generally expected. That’s just the amount that was currently sitting on credit cards. If you do the math at the staggering 25% interest rate that some credit cards are subject to, you’ve got an amount of credit card debt that is by all intents and purposes insurmountable by a lot of households. For this type of debt, the Dave Ramsey, “attack the debt with a sledgehammer” is probably the best approach. However, once that type of debt is gone and one if left with only other lesser interest rate debt, there could be a much better direction to take.

This is where I suggest moving towards an interest rate tree. An interest rate tree is a sheet that one can make that documents what loans your household has and how much the interest rates are on those loans. Order the interest rates from highest to lowest. All loans that have a rate of interest that is greater than 3% should be immediately attacked and taken off the board with every bit of finances that a household can possibly generate per pay check. However, those who are below 3% may be better to simply pay over the life of the loan.

Sample Interest Rate Tree

Jim Bob’s Credit Card – 27% - $7,000
Jo Bob’s Credit Card – 20% - $5,000
Sweet Car Loan – 2% - $15,000
The Crib Loan – 1.9% - $156,000

You see, generally, if an investor chooses to move new capital into a dividend investment portfolio, that portfolio could be expected to make at least a 3% dividend if allocated into companies that issue dividends greater than 3% yield on cost. This then forces your money to work for you quicker over time than simply paying down debts. Where higher than the required payments towards paying off debt sooner only pay off debt and don’t generate income, a dividend investment portfolio can not only make that money work for you but also compound over time which equates to far greater net income raising power. This isn’t to say that one should stop paying their $200/month car payment. It’s simply to say that instead of overpaying and spending more than the $200/month simply to pay it faster, it would be a smarter use of capital to allocate that cash into solid dividend paying stocks. This way the loans are still being paid but capital is also being generated for an auxiliary effect for turbo charged payoff power.

All this being said, this is not a one size fits all approach. For example, if I know that I get discouraged easily if I’m not seeing large movement every month, I may opt to just continually attack the loans instead. If however I am looking to truly optimize my money and I know that I can see the larger picture without being tempted, this is an excellent way of making money while still paying down debts.

1 comment:

  1. Very nice write up. Paying off debt is important with creating a nice portfolio. Freeing up that cash is a great feeling. All the best.