Interesting Debt Theory...

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zmcpherson
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Interesting Debt Theory...

Post by zmcpherson »

A few friends and I were discussing what another friend should do with his newly acquired $15k.

For the most part we agreed that he should pay off his credit cards (2k@18-20%), car (8k@8%), and then put the rest into his company 401k up to matching and then into an IRA with whatever is left over. Subtle differences here and there but for the most part, some strategy like that.

Then another friend suggested he put all of it into 401k/IRA and pay off the credit card and car payment normally in their respective times.

Which I thought was nuts at first, because investments will never earn 18-20% and even 8% can sometimes be hard to get.

But his logic behind it is this:

We are late 20's trying to save for retirement 35ish years from now.
2k @ 20% for an extra year and 8k @ 8% for an extra 3 years is roughly an extra $2500 in interest.

We are so young now that the compound interest we have the potential in earning far outweighs whatever high APR that we might have to pay in the short term. Its true that, in the short term, it would make better financial sense to pay off the high interest liabilities. Again, it would be foolish to hope for 18-20% returns. However, thinking long term, and in this particular instance, putting that 15k into a 401k at 8% over 35 years (even if he never put another penny into it again) would actually yield $245k.

I thought this was a fascinating user case where - ignoring high APR debt in favor of long term compounding interest, might actually have a leg to stand on.

I would love to get the boglehead perspective on this though, I have a feeling this could turn into a really interesting thread.

When does investing into compounding interest outweigh high interest liabilities? :happy
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zmcpherson
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Re: Interesting Debt Theory...

Post by zmcpherson »

I was trying to find any articles I could to support the position, and this one touches on it: http://www.nbcnews.com/technology/when- ... 6C10111142
sport
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Re: Interesting Debt Theory...

Post by sport »

He might do even better to pay off the loans, and then take the money for the loan payments, he no longer needs to make, and put that into the 401k. It would just take a little discipline on his part to make sure he actually does put the money into the 401k plan later rather than spend it.
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Re: Interesting Debt Theory...

Post by harikaried »

zmcpherson wrote:2k @ 20% for an extra year and 8k @ 8% for an extra 3 years is roughly an extra $2500 in interest.
Where is the money coming from to pay this interest (and principal) if not from the newly acquired $15k? Another way to look at this is if the loans are paid off now, $2500 in interest is saved that can be invested, and whatever would have been used to pay back the principal can also be invested.
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Re: Interesting Debt Theory...

Post by desertgoose »

This is really just a math problem. By paying off the high interest rate debt sooner, you pay less interest, meaning you have more money that can compound over the 35 year period. So your friend should payoff the high interest debt.

Here is a link to the math. https://docs.google.com/spreadsheet/ccc ... sp=sharing
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Re: Interesting Debt Theory...

Post by dickenjb »

Rubbish. Compound interest at 8% won't equal 18 to 20%. Pay off the loans and invest the rest. What about an e-fund?
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Re: Interesting Debt Theory...

Post by jimbojones »

The logic would continue that putting all your expenses on CC while paying only the minimum each month would allow you to max out your investments, generating higher and higher gains in the future.

I'm not sure how you've calculated your figures, but don't exclude the impact of eventually paying back those loans. In the "invest $15K scenario", you still have to pay back the $2K loan at Y1 and the $8K loan over Y1, Y2, and Y3. The future value of those payments (compounded at 8% over ~35 years) will eat up a significant amount of your $245K projection.

Luckily the debts are small, but I'd pay them off and invest the remaining $5K.
MathWizard
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Re: Interesting Debt Theory...

Post by MathWizard »

You were right the first time.

Pay off the high interest debt first.

Of course he needs to be disciplined and not run up another $2K on credit cards. If he is not disciplined
enough to do that, then he is in financial trouble whatever happens with the $15K.

The only time you would not want to pay off is when you have an issue of cash flow, but 18% is pretty steep
for cash flow, but then I did have a little bit of short term 18% debt back when I was in grad school and
just got married, but that was when prime was 12%. 18% now is horrible.
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Re: Interesting Debt Theory...

Post by Ged »

Depends on how much the matching is. It may outweigh the CC interest.
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zmcpherson
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Re: Interesting Debt Theory...

Post by zmcpherson »

desertgoose wrote:This is really just a math problem. By paying off the high interest rate debt sooner, you pay less interest, meaning you have more money that can compound over the 35 year period. So your friend should payoff the high interest debt.

Here is a link to the math. https://docs.google.com/spreadsheet/ccc ... sp=sharing
Technically this spreadsheet is not 100% accurate. You are definitely provide the most compelling argument though.

For the sake of making everything equal, we would have to assume that the money saved from paying of the loans immediately were then reinvested monthly.

So if its a $2400 loan over the course of 12 months, $200 a month would then be invested for 12 months.
Likewise, an $8000 at 8% over 3 years = $250ish per month (correct me if I'm wrong)

So if scenario 1 was paying off the debt right away:
5k invested immediately (8% over 35 years)
then $450 invested every month for the first 12 months ($200 + $250)
then $250 invested for the 24 months after that.
vs
Scenario 2
15k sitting for 35 years at 8%


I guess the difference would be, instead of saying $5400 ($450x12) was invested the first year at 8%. It would really be $2700 at 8% because not all $5400 was available at the end of the year
Last edited by zmcpherson on Tue Jul 30, 2013 6:45 pm, edited 1 time in total.
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Re: Interesting Debt Theory...

Post by JDaniels »

This thinking may also cause something much more dangerous; having credit card debt as a "normal" feeling.
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zmcpherson
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Re: Interesting Debt Theory...

Post by zmcpherson »

JDaniels wrote:This thinking may also cause something much more dangerous; having credit card debt as a "normal" feeling.
Nooo!! Ive always hated "The Psychology of Debt" argument (I knew someone would bring it up). With money, finances, and anything else that has concrete numbers, we have the benefit of looking at real models that have right answers. To muddle feelings into it is what creates a more dangerous environment.

At 35 years and 8% return, there is a right answer to get the best possible return. High debt, low debt, or no debt, there is no normal - a model needs to be built for every situation. If carrying higher debt is better for a 35 year plan, then carry a higher debt.

That's why Im here, to model build : )
Bread
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Re: Interesting Debt Theory...

Post by Bread »

Something else that I haven't seen mentioned: The interest rate on the debt is pretty much a given. The interest rate expected in the 401K is an assumption. What is the probability that one gets 8% in an investment going forward? You may want to consider adjusting your interest rate on your investments in the 401K to something more conservative; an expected value resulting from 8% multiplied by probability-of-success.
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Re: Interesting Debt Theory...

Post by JDaniels »

zmcpherson wrote:
JDaniels wrote:This thinking may also cause something much more dangerous; having credit card debt as a "normal" feeling.
To muddle feelings into it is what creates a more dangerous environment.
Lol, my point exactly :D
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Re: Interesting Debt Theory...

Post by ruralavalon »

Ged wrote:Depends on how much the matching is. It may outweigh the CC interest.
Yes, match before debt. Then the high interest debt before any other investing.

EDIT; for spelling.
Last edited by ruralavalon on Wed Jul 31, 2013 4:55 am, edited 1 time in total.
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Re: Interesting Debt Theory...

Post by hazlitt777 »

zmcpherson wrote:
JDaniels wrote:This thinking may also cause something much more dangerous; having credit card debt as a "normal" feeling.
Nooo!! Ive always hated "The Psychology of Debt" argument (I knew someone would bring it up). With money, finances, and anything else that has concrete numbers, we have the benefit of looking at real models that have right answers. To muddle feelings into it is what creates a more dangerous environment.

At 35 years and 8% return, there is a right answer to get the best possible return. High debt, low debt, or no debt, there is no normal - a model needs to be built for every situation. If carrying higher debt is better for a 35 year plan, then carry a higher debt.

That's why Im here, to model build : )
Beware of models. Investing and economic projections are not something that can be predicted via mathematical models.

All math does for investors is describe what would happen if things turn out as projected. Math can be misleading when used by investors in that it insinuates more certainty than truly exists in this field.

With this in mind, I would pay off the debts first. Remember, if your investments go bad, the debt will still be there.
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Re: Interesting Debt Theory...

Post by patrick »

zmcpherson wrote:
JDaniels wrote:This thinking may also cause something much more dangerous; having credit card debt as a "normal" feeling.
Nooo!! Ive always hated "The Psychology of Debt" argument (I knew someone would bring it up). With money, finances, and anything else that has concrete numbers, we have the benefit of looking at real models that have right answers. To muddle feelings into it is what creates a more dangerous environment.

At 35 years and 8% return, there is a right answer to get the best possible return. High debt, low debt, or no debt, there is no normal - a model needs to be built for every situation. If carrying higher debt is better for a 35 year plan, then carry a higher debt.

That's why Im here, to model build : )
There is a normal case. Normally if you have 10000 in debt on which you pay 18% interest and 10000 in investments on which you receive 8%, you lose 1800 and gain 800, for a net loss of 1000. If you use the money to pay the debt, you neither receive nor pay interest, so your 1000 loss turns to 0. This always happens to your total net worth when you are paying interest at a high rate and receiving interest at a lower rate.

The returns on the initial investment may well be large, but from the first post it seems that you ignore that you'd have less money available to invest later. Not only would the principal have to be paid later, but also the interest would have to be paid later. And if the interest is 18% then for each year you hold it the amount you could invest later drops by 18% of the debt amount, which is more than the 8% of the debt amount that you gained as a result of keeping the debt in order to make the investment.

Working out a specific model would only be needed for special cases such as when the money in question would get a match in the 401K (and then only up to the amount that would be matched ... clearly better to pay the debt once you've maxed out the match), or if there's a good chance the debt won't have to be paid because it will be forgiven or erased in bankruptcy.
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Re: Interesting Debt Theory...

Post by HenryPorter »

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Texas hold em71
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Re: Interesting Debt Theory...

Post by Texas hold em71 »

zmcpherson wrote:
JDaniels wrote:This thinking may also cause something much more dangerous; having credit card debt as a "normal" feeling.
Nooo!! Ive always hated "The Psychology of Debt" argument (I knew someone would bring it up). With money, finances, and anything else that has concrete numbers, we have the benefit of looking at real models that have right answers. To muddle feelings into it is what creates a more dangerous environment.

At 35 years and 8% return, there is a right answer to get the best possible return. High debt, low debt, or no debt, there is no normal - a model needs to be built for every situation. If carrying higher debt is better for a 35 year plan, then carry a higher debt.

That's why Im here, to model build : )

As long as your model has a scenario where the investment grows in some year and plummets in others, while the debt continues to grow at a constant rate.
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Re: Interesting Debt Theory...

Post by grabiner »

The theory makes sense in some situations, but not here.

Currently, he is far from maxing out his retirement accounts. If he pays off the credit cards now with $15,000, then he will have $17,500 more to contribute to the retirement accounts, guaranteed, in the next few years. If he invests the $15,000 in his retirement accounts, he cannot earn $2500 over the same term risk-free.

The situation in which keeping the debt might be worthwhile would be if maxing out the retirement accounts now allowed him to save tax-deferred rather than taxable in the future. Even then, it's not a good deal at these rates. However, if you have a 3% return after-tax on your mortgage and can earn 2.5% risk-free in your retirement accounts, it might still be better to max out the retirement accounts before making extra mortgage payments; otherwise, when the mortgage is gone, you will have more money than you are allowed to invest in retirement accounts, and thus you will earn less than 2.5% on the taxable investments you are forced to make.

(One other exception is an employer match. If the employer gives a 50% match on the first $3000 he puts into the 401(k), that is an immediate 50% return, which is better than the return on the credit cards.)
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Re: Interesting Debt Theory...

Post by JoMoney »

zmcpherson wrote: When does investing into compounding interest outweigh high interest liabilities? :happy
The interest on liabilities compounds against you the same way interest earned compounds for you. :(

As you stated, "it would be foolish to hope for 18-20% returns" (not foolish to hope, but foolish to expect)... However, the reality is he is effectively GUARANTEED 18-20% returns by paying on the credit cards. If he does not pay the credit card his net-worth will decrease at this rate and compound just as quickly (possibly quicker because of additional fees and penalty rates the credit cards would apply if he paid nothing). There is no magic to a retirement account that changes this.

The only way not paying off the credit card works to the advantage of the retirement account is if he dies. Then his benneficiaries might receive the retirement account outside of probate, and if he doesn't have any other assets there's nothing left in the estate to pay his creditors after his death.
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Re: Interesting Debt Theory...

Post by Valuethinker »

OP's math doesn't work.

It ignores the cash flow you save by paying down high interest debt. Which you could then reinvest.

The correct computation uses *after tax* cash flows, and there missing the chance to invest in tax deferred accounts like 401k, where you can never catch that back up, is tricky.

Nonetheless achieving say an 8% *after tax* return by paying down consumer debt is unmatchable in investing-- the expected returns of equity investing (with far higher volatility, ie greater chance of not achieving them) is is only 6-8% pa.

The breakeven point is probably debt at around 2-3% after tax. At that point, you are close to the returns on investing in equivalently safe assets (Treasury Bonds).

A further complication is your inflation expectations. If your debt interest rate is fixed, and you expect inflation to increase significantly, it could be worth deferring paying down debt. A long term fixed rate debt is an inflation hedge.

Generally that is only worth doing with a mortgage-- ie not paying down your mortgage early, to increase your investments. And only true up to the maximum of tax deferred contributions you can make.

A debt which doesn't have recourse to your inheritors is, in some sense, a form of life insurance. Therefore some forms of US student debt might be worth never paying back, particularly if you have limited life expectancy (most things in personal finance change if you have limited life expectancy). HOWEVER that opens up an ethical issue: the low interest rate is the result of US government policy, you have borrowed it from the taxpayers of the future. You have to decide whether it is ethical to not repay that money if you have the ability so to do.

Such conversations with oneself are, in my experience, well considered after a visit to a place like Arlington -- best to consider your sacrifices in the light of those of others.

As with all such ethical questions, no external advice (least of all mine) can really shape your answer. It's just worth knowing it's there.
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Re: Interesting Debt Theory...

Post by z3r0c00l »

zmcpherson wrote:\

Then another friend suggested he put all of it into 401k/IRA and pay off the credit card and car payment normally in their respective times.

Which I thought was nuts at first, because investments will never earn 18-20% and even 8% can sometimes be hard to get.

We are late 20's trying to save for retirement 35ish years from now.
2k @ 20% for an extra year and 8k @ 8% for an extra 3 years is roughly an extra $2500 in interest.

I thought this was a fascinating user case where - ignoring high APR debt in favor of long term compounding interest, might actually have a leg to stand on.
You were right, that logic is nuts. You cannot expect 8% per year until retirement. If this were a 4% mortgage there would be an argument to make, but 8%? No way.
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Valuethinker
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Re: Interesting Debt Theory...

Post by Valuethinker »

grabiner wrote:The theory makes sense in some situations, but not here.

Currently, he is far from maxing out his retirement accounts. If he pays off the credit cards now with $15,000, then he will have $17,500 more to contribute to the retirement accounts, guaranteed, in the next few years. If he invests the $15,000 in his retirement accounts, he cannot earn $2500 over the same term risk-free.

The situation in which keeping the debt might be worthwhile would be if maxing out the retirement accounts now allowed him to save tax-deferred rather than taxable in the future. Even then, it's not a good deal at these rates. However, if you have a 3% return after-tax on your mortgage and can earn 2.5% risk-free in your retirement accounts, it might still be better to max out the retirement accounts before making extra mortgage payments; otherwise, when the mortgage is gone, you will have more money than you are allowed to invest in retirement accounts, and thus you will earn less than 2.5% on the taxable investments you are forced to make.

(One other exception is an employer match. If the employer gives a 50% match on the first $3000 he puts into the 401(k), that is an immediate 50% return, which is better than the return on the credit cards.)
+1 which I neglected.

Employer match-- it's usually worth getting that, because it is a 100% rate of return.

Generally though there is a case for not paying down mortgage in preference for investing, but with almost all other kinds of debt, that is not the case.
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Re: Interesting Debt Theory...

Post by nisiprius »

One thing that you need to allow for is that paying down debt is basically unpleasant and boring, an ugly chore that has no fun in it whatsoever. It doesn't have the remote potential of making you rich. Therefore, there is a tendency to struggle against it and find all sorts of excuses and rationalizations not to do it. I shouldn't get an annual physical because of the potential danger of overdiagnosis and overtreatment. I shouldn't change the oil in the car per schedule because the car manufacturer just wants to build business for their service departments, and disposing of used oil is environmentally harmful. I shouldn't clean the house today because dirt keeps my immune system tuned up.
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Re: Interesting Debt Theory...

Post by Valuethinker »

nisiprius wrote:One thing that you need to allow for is that paying down debt is basically unpleasant and boring, an ugly chore that has no fun in it whatsoever. It doesn't have the remote potential of making you rich. Therefore, there is a tendency to struggle against it and find all sorts of excuses and rationalizations not to do it. I shouldn't get an annual physical because of the potential danger of overdiagnosis and overtreatment. I shouldn't change the oil in the car per schedule because the car manufacturer just wants to build business for their service departments, and disposing of used oil is environmentally harmful. I shouldn't clean the house today because dirt keeps my immune system tuned up.
However it always helps to have a 'towards' and the 'towards' of repaying debt is *debt free*.

The discharge of a debt is a wonderful thing. A fixed cost in your life that just disappears, a monthly expense just gone.

A friend of mine who is a sometime real rocket scientist (ie NASA) and knows nothing about finance put it this way once 'if you borrow money, you never get t spend as much money as you would have if you had spent your own cash-- because of the interest bill'.

That is *obvious*. And *trivial*. But I'd never framed the question that way: if you want to spend $100, you get $100 of value (plus accrued interest, if any) if you save it and spend it, and *less than* $100 if you borrow it.

It did make debt repayment that bit easier. Although if you factor in inflation, the calculation can get more complicated (essentially if you somehow luck into unexpected inflation and even a negative real interest rate).
ML 59
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Re: Interesting Debt Theory...

Post by ML 59 »

He should already be capturing the company match in his 401(k). No matter what.

From there I would:
Pay off debt - highest interest first.
Invest most of the remainder.
Have fun with some of it.

Which is to say:
Take care of business.
Save for the future.
Enjoy life today.
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Re: Interesting Debt Theory...

Post by TheTimeLord »

zmcpherson wrote:A few friends and I were discussing what another friend should do with his newly acquired $15k.

For the most part we agreed that he should pay off his credit cards (2k@18-20%), car (8k@8%), and then put the rest into his company 401k up to matching and then into an IRA with whatever is left over. Subtle differences here and there but for the most part, some strategy like that.

Then another friend suggested he put all of it into 401k/IRA and pay off the credit card and car payment normally in their respective times.

Which I thought was nuts at first, because investments will never earn 18-20% and even 8% can sometimes be hard to get.

But his logic behind it is this:

We are late 20's trying to save for retirement 35ish years from now.
2k @ 20% for an extra year and 8k @ 8% for an extra 3 years is roughly an extra $2500 in interest.

We are so young now that the compound interest we have the potential in earning far outweighs whatever high APR that we might have to pay in the short term. Its true that, in the short term, it would make better financial sense to pay off the high interest liabilities. Again, it would be foolish to hope for 18-20% returns. However, thinking long term, and in this particular instance, putting that 15k into a 401k at 8% over 35 years (even if he never put another penny into it again) would actually yield $245k.

I thought this was a fascinating user case where - ignoring high APR debt in favor of long term compounding interest, might actually have a leg to stand on.

I would love to get the boglehead perspective on this though, I have a feeling this could turn into a really interesting thread.

When does investing into compounding interest outweigh high interest liabilities? :happy
Payoff the debt then take the monthly payments he was making on credit cards and car and invest in his 401k or a taxable account. That way he would invest not only the 15K but all the interest he saved. Problem solved, not thinking I would take much financial advice from that friend.
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Re: Interesting Debt Theory...

Post by greg24 »

If you are going to run the numbers, you have to consider the tax avoidance by investing in a 401k.
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Re: Interesting Debt Theory...

Post by sesq »

If his credit doesn't suck he should be able to re-fi that car loan to around 2%. Penfed, USAA, local credit unions. Odds are his credit is shaky though.
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Re: Interesting Debt Theory...

Post by HomerJ »

hazlitt777 wrote:Beware of models. Investing and economic projections are not something that can be predicted via mathematical models.

All math does for investors is describe what would happen if things turn out as projected. Math can be misleading when used by investors in that it insinuates more certainty than truly exists in this field.

With this in mind, I would pay off the debts first. Remember, if your investments go bad, the debt will still be there.
This... 100x this.

Paying off debt is a guarenteed return. A model that depends on uncertain returns is not guarenteed to be correct.
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Re: Interesting Debt Theory...

Post by zmcpherson »

Ged wrote:Depends on how much the matching is. It may outweigh the CC interest.
After running multiple models with ranging returns 5-10%, also changing the credit card financing charges (anywhere from 15-20%), 401k matching has the largest impact. It looks like it is always better to get the 401k matching before paying off any sort of debt (as long as you can eventually afford the debt I suppose). ML59 and Valuethinker also said similar things. It is after all, 100% free return on your money. Only after that does the debt make sense.
sesq wrote:If his credit doesn't suck he should be able to re-fi that car loan to around 2%. Penfed, USAA, local credit unions. Odds are his credit is shaky though.
Also not a bad idea on refinancing the loan, at 2% it would be waaay better to carry the life of the loan and invest the money. Though, I'm not exactly sure what about the story made you think his credit is shaky lol.
Greg24 wrote:If you are going to run the numbers, you have to consider the tax avoidance by investing in a 401k.
Never even thought about that, great point though. At this junction though, I'm tired of looking at the numbers when its not even my money : P


After running all the numbers though, it looks like this nbc financial guy is full of crap http://www.nbcnews.com/technology/when- ... 6C10111142, at least as it pertains to the last part about credit card debt.

interesting thread for sure.
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Re: Interesting Debt Theory...

Post by jimbojones »

Sorry, I overlooked the article when you linked to it at the beginning. There are some good points sprinkled in there, like living like you're still in college, but the paragraph about maintaining 15% credit card debt in order to fund retirement is dangerous and poorly explained.
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Re: Interesting Debt Theory...

Post by JoMoney »

zmcpherson wrote:
sesq wrote:If his credit doesn't suck he should be able to re-fi that car loan to around 2%. Penfed, USAA, local credit unions. Odds are his credit is shaky though.
Also not a bad idea on refinancing the loan, at 2% it would be waaay better to carry the life of the loan and invest the money. Though, I'm not exactly sure what about the story made you think his credit is shaky lol.
Greg24 wrote:If you are going to run the numbers, you have to consider the tax avoidance by investing in a 401k.
Never even thought about that, great point though. At this junction though, I'm tired of looking at the numbers when its not even my money : P

interesting thread for sure.
I don't know how there can be so much discussion on this. There shouldn't even be a need for simulations. It should be apparent as soon as you see the interest rates. The interest you owe will compound against you at whatever rate the debt is set at. The only way it makes sense is if you can earn a higher interest by not paying it. If you want to compare the benefits of tax free growth you can make a simple rough adjustment when you look at the interest rate you expect to earn. If you expect to earn 10% and are in a 25% tax bracket, then you can roughly assume you're only netting 7.5% if it's not in a tax sheltered account. This is still less than 18-20% so you have no way to profit from it.
Yes, if you can somehow refinance into a 2% loan, and then invest the money at 5% THEN you have an opportunity to profit from this. This is typicaly called a "carry trade". However, you can very rarely find opportunities to borrow at a fixed interest rate on consumer debt. Most credit cards have variable rates. If the interest rate moves against you, you may have to unwind your investment at an un-opportunistic time.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Interesting Debt Theory...

Post by sesq »

zmcpherson wrote: Though, I'm not exactly sure what about the story made you think his credit is shaky lol.
Paying 8% on a car loan when even without the historic drops 4-6% has been out there for a few years. Paying 20% on a credit card when 0 to 9% has out there. It could be shaky credit, or a lack of curiosity/desire/knowledge to find the best deal.
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Re: Interesting Debt Theory...

Post by JoMoney »

sesq wrote:
zmcpherson wrote: Though, I'm not exactly sure what about the story made you think his credit is shaky lol.
Paying 8% on a car loan when even without the historic drops 4-6% has been out there for a few years. Paying 20% on a credit card when 0 to 9% has out there. It could be shaky credit, or a lack of curiosity/desire/knowledge to find the best deal.
An 8% car loan isn't necessarily bad, especially if this is an older car and the borrower has little to no equity/down payment in it.
It's very difficult to borrow money below 8% unless it's backed by collateral (a car with 100% loan to value is not collateral). Often new car manufacturers will subsidize loans to make them lower, otherwise there's typically a requirement for a big down payment or high-value trade in to get the really low rates.

The areas where consumers get really low rates without necessarily having some sort of collateral at risk are home loans and student loans, in those cases the low rate is only because the government is subsidizing the loan and guaranteeing the bank will be repaid.
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Re: Interesting Debt Theory...

Post by nisiprius »

HomerJ wrote:
hazlitt777 wrote:With this in mind, I would pay off the debts first. Remember, if your investments go bad, the debt will still be there.
This... 100x this. Paying off debt is a guarenteed return. A model that depends on uncertain returns is not guarenteed to be correct.
Sure, but people who don't want to pay down their debt never see it that way. They do not acknowledge the concept of cost of risk. They want to put their low-risk-to-the-bank loan rate onto one side of the scale, and the "Siegel's Constant" rate they think they can earn in stocks on the other side, and ignore the risk because they think they are willing to gamble on it not showing up.

They compare apples to oranges. No They compare solid rocks to Mexican jumping beans.

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Re: Interesting Debt Theory...

Post by Default User BR »

HomerJ wrote:Paying off debt is a guarenteed return. A model that depends on uncertain returns is not guarenteed to be correct.
What does this have to do with anything? You can never GUARANTEE that you'll beat a risk-free return with a risky investment. That's why there's a risk premium. With your theory, you'd never invest in anything that wasn't risk-free. After all, you might not do as well. Why is paying off a loan any different than choosing between stocks and CDs?

If you want to pay off loans for "feel good" reasons, just do it. You don't need a pseudo-financial reason.


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Re: Interesting Debt Theory...

Post by Default User BR »

nisiprius wrote:Sure, but people who don't want to pay down their debt never see it that way. They do not acknowledge the concept of cost of risk. They want to put their low-risk-to-the-bank loan rate onto one side of the scale, and the "Siegel's Constant" rate they think they can earn in stocks on the other side, and ignore the risk because they think they are willing to gamble on it not showing up.
There are always fools, on any side an argument. However, this is a total strawman. Of course it's riskier to not go totally with risk-free investments. That's why the word "risk" is in there. Holding a low-rate loan and using it as leverage to increase riskier investments is indeed, well, riskier. But so what? So is buying stocks instead of CDs. Are people who do that ignoring the cost of risk? No. Or hopefully not, anyway. Are those people gambling that the risk of stocks won't show up? They're hoping that over time the risk will pay off. But if they know what they're doing, they'll know it might not. So does the person who takes advantage of cheap leverage. Or they should.


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Re: Interesting Debt Theory...

Post by pkcrafter »

I'm still wondering why anyone would pay 8% for a car loan. Does your friend have a low credit score? Is is now making regular monthly contributions to the 401k? Does he have an emergency fund?
zmcpherson
JDaniels wrote:This thinking may also cause something much more dangerous; having credit card debt as a "normal" feeling.
Nooo!! Ive always hated "The Psychology of Debt" argument (I knew someone would bring it up). With money, finances, and anything else that has concrete numbers, we have the benefit of looking at real models that have right answers. To muddle feelings into it is what creates a more dangerous environment.
You can't dismiss 'the psychology of debt' argument because you hate it. The fact is people do it. If not true, then your friend would not have 2k debt with 18-20% interest, nor would he have a car loan at 8%. More than anything else, your friend has to learn how to manage money.

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Re: Interesting Debt Theory...

Post by manwithnoname »

If he can borrow 10k from his 401k plan, use the 401k funds to payoff the 10k in loans because 401k interest rate should be about 5% and the interest he pays will be credited to his account in the plan instead of the CC co. Interest paid to 401k plan over 3 years will be less than that which would be paid on other loans. E.g. $8632 total payment for car loan over 3 years @ 5% and $2158 on 2000 cc loan @ 5% over 3 years instead of $2400 over 1 year. total interest payment $790 v $2500.
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Re: Interesting Debt Theory...

Post by JoMoney »

manwithnoname wrote:If he can borrow 10k from his 401k plan, use the 401k funds to payoff the 10k in loans because 401k interest rate should be about 5% and the interest he pays will be credited to his account in the plan instead of the CC co. Interest paid to 401k plan over 3 years will be less than that which would be paid on other loans. E.g. $8632 total payment for cc loan over 3 years @ 5% and $2158 on 2000 loan @ 5% over 3 years instead of 2400 over 1 year. total interest payment $790 v $2500.
There is no benefit to this. The money he's borrowing from himself will come out of the investments and stop earning interest. The money he uses to pay back the 401k loan will come from his "after tax" paycheck. The only one who profits from this is the $50 paper work fee the 401k administrator will charge for the loan paperwork.
If he currently has money outside the 401k, just pay off the credit card and then he can increase the contributions to the 401k.
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Re: Interesting Debt Theory...

Post by pkcrafter »

JoMoney wrote:
manwithnoname wrote:If he can borrow 10k from his 401k plan, use the 401k funds to payoff the 10k in loans because 401k interest rate should be about 5% and the interest he pays will be credited to his account in the plan instead of the CC co. Interest paid to 401k plan over 3 years will be less than that which would be paid on other loans. E.g. $8632 total payment for cc loan over 3 years @ 5% and $2158 on 2000 loan @ 5% over 3 years instead of 2400 over 1 year. total interest payment $790 v $2500.
There is no benefit to this. The money he's borrowing from himself will come out of the investments and stop earning interest. The money he uses to pay back the 401k loan will come from his "after tax" paycheck. The only one who profits from this is the $50 paper work fee the 401k administrator will charge for the loan paperwork.
If he currently has money outside the 401k, just pay off the credit card and then he can increase the contributions to the 401k.
+1.
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Re: Interesting Debt Theory...

Post by jimbojones »

JoMoney wrote:
manwithnoname wrote:If he can borrow 10k from his 401k plan, use the 401k funds to payoff the 10k in loans because 401k interest rate should be about 5% and the interest he pays will be credited to his account in the plan instead of the CC co. Interest paid to 401k plan over 3 years will be less than that which would be paid on other loans. E.g. $8632 total payment for cc loan over 3 years @ 5% and $2158 on 2000 loan @ 5% over 3 years instead of 2400 over 1 year. total interest payment $790 v $2500.
There is no benefit to this. The money he's borrowing from himself will come out of the investments and stop earning interest. The money he uses to pay back the 401k loan will come from his "after tax" paycheck. The only one who profits from this is the $50 paper work fee the 401k administrator will charge for the loan paperwork.
If he currently has money outside the 401k, just pay off the credit card and then he can increase the contributions to the 401k.
Not every 401k loan works like this, FWIW. Some make the loan separately using the investments as collateral.
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Re: Interesting Debt Theory...

Post by JoMoney »

jimbojones wrote: Not every 401k loan works like this, FWIW. Some make the loan separately using the investments as collateral.
That sounds very intriguing, but also sounds illegal from what I understand of retirement accounts (but I'm no expert).
Generally the IRS forbids you from using a retirement account as collateral and may make the account ineligible for the special tax treatment if used in that fashion.
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Re: Interesting Debt Theory...

Post by jimbojones »

JoMoney wrote:
jimbojones wrote: Not every 401k loan works like this, FWIW. Some make the loan separately using the investments as collateral.
That sounds very intriguing, but also sounds illegal from what I understand of retirement accounts (but I'm no expert).
Generally the IRS forbids you from using a retirement account as collateral and may make the account ineligible for the special tax treatment if used in that fashion.
You've got me worried. I tried to find some IRS literature to get an answer, but I didn't find anything stipulating that the plan couldn't lend the money with the investment assets as collateral. Do you have a link to anything?
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Re: Interesting Debt Theory...

Post by JoMoney »

jimbojones wrote:
JoMoney wrote:
jimbojones wrote: Not every 401k loan works like this, FWIW. Some make the loan separately using the investments as collateral.
That sounds very intriguing, but also sounds illegal from what I understand of retirement accounts (but I'm no expert).
Generally the IRS forbids you from using a retirement account as collateral and may make the account ineligible for the special tax treatment if used in that fashion.
You've got me worried. I tried to find some IRS literature to get an answer, but I didn't find anything stipulating that the plan couldn't lend the money with the investment assets as collateral. Do you have a link to anything?
Oh boy... I thought this was going to be easy, I'm coming up zilch with "official" IRS documents. I can find lots of other web posts from other people stating effectively the same thing, but not necessarily from the IRS (at least not in human readable form).
But if you were aloud to stay invested, while at the same time taking the money out, it would effectively be allowing you use margin inside your 401k... like i said, this is very intriguing... but somehow i suspect its very unusual that a 401k plan would allow this..
I have found that for an IRA account IRS Publication 590 states that using it as collateral on a loan is a "prohibited transaction", just not any similar verbiage regarding qualified retirement plans/401k.
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Re: Interesting Debt Theory...

Post by MN Finance »

JoMoney wrote:
jimbojones wrote:
JoMoney wrote:
jimbojones wrote: Not every 401k loan works like this, FWIW. Some make the loan separately using the investments as collateral.
That sounds very intriguing, but also sounds illegal from what I understand of retirement accounts (but I'm no expert).
Generally the IRS forbids you from using a retirement account as collateral and may make the account ineligible for the special tax treatment if used in that fashion.
You've got me worried. I tried to find some IRS literature to get an answer, but I didn't find anything stipulating that the plan couldn't lend the money with the investment assets as collateral. Do you have a link to anything?
Oh boy... I thought this was going to be easy, I'm coming up zilch with "official" IRS documents. I can find lots of other web posts from other people stating effectively the same thing, but not necessarily from the IRS (at least not in human readable form).
But if you were aloud to stay invested, while at the same time taking the money out, it would effectively be allowing you use margin inside your 401k... like i said, this is very intriguing... but somehow i suspect its very unusual that a 401k plan would allow this..
I have found that for an IRA account IRS Publication 590 states that using it as collateral on a loan is a "prohibited transaction", just not any similar verbiage regarding qualified retirement plans/401k.
Where did this discussion come from? Retirement loans use the investments as collateral, that's no mystery. I just picked up loan paperwork for an old account I may access toward the end of the year if cash is tight. Money goes into the fixed account and earns 3% while the loan floats around 5%. Collateral is why you can only take a loan of 50% of the account value up to $50k.

I also can't believe this question turned into such a lengthy discussion. Such a simple issue.
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Re: Interesting Debt Theory...

Post by JoMoney »

MN Finance wrote: Where did this discussion come from? Retirement loans use the investments as collateral, that's no mystery. I just picked up loan paperwork for an old account I may access toward the end of the year if cash is tight. Money goes into the fixed account and earns 3% while the loan floats around 5%. Collateral is why you can only take a loan of 50% of the account value up to $50k.
You can take a loan from the account, but in the instances I've heard/seen, the funds are actually withdrawn from the investments. In this scenario being suggested where the investments are aloud to stay in the account, and then somehow being aloud to borrow against it without actually decreasing the ability of the 401k account to grow, it creates all kinds of opportunities.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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