July 2006 - The curious mind (i.e. me) likes to engage in a myriad of good conversations and one of our favorite subjects is economics. Often when discussing economics the curious mind debates whether personal debt is good or bad. Today’s discussion regards risk and leverage in simple terms.
Let’s start the debate with a simple example. Say we buy a house for $250,000 and get a 30 year fixed interest rate of 6%. The monthly payment is around $1,500 a month of which a surprisingly large amount is used for interest during the first ten to fifteen years of the loan. Over the life of the loan we pay almost $290,000 in just interest, which gives us indigestion just thinking about such a nightmare.
All the interest is causing loss of sleep so instead of paying $1,500 a month, why not pay $2,000 a month and pay off the loan early? Just think of it, pay off the loan in say 15-17 years instead of 30 and save thousands of dollars (close to half) in interest! But does paying off the loan make sound economic sense? As with most things, it depends.
Financial pundits have a concept called financial leverage, which terms the simple idea that borrowing money at a low interest (e.g. 6%) rate and investing it in something returning a higher interest rate (e.g. 10%) is advantageous. The borrower in this example is rewarded or punished in regards to the difference (i.e. risk) between the rates. Let’s apply this little concept called leverage to our agonizing $250,000 home loan with a 6% interest rate.
The lender is borrowing you $250,000 at 6%. Over the course of time history shows the S&P 500 stock market index returns close to 10%. Remember that $500 extra you were going to pay on your mortgage? Instead of doing so, some would argue to take on additional “risk” and “leverage” yourself by investing it in another investment (e.g. stock/bond markets, rental units, or those old baseball cards in your basement). If the return you receive on your investment is over 6%, even though you’d pay more in interest (possibly double), oddly enough you will come out ahead in economic terms. On the contrary, if the return received falls below 6%, your leverage works against you and punishes your pocket book for the risk.
So when asking “Should I pay off my debt?” first compare the borrowing rate verses the expected return rate. Secondly ask how much leverage and risk your stomach can handle. If you’re willing to leverage yourself, stretch that 6% mortgage as long as you can. If you don’t like risk, pay off that debt as soon as you can and enjoy the lack of debt payments.
1 comment:
Good article! Lets put it to the test.
Lets assume your marginal tax rate is 25%
That means $1 of mortgage interest saves $0.25 of tax on your income.
Now lets say instead of investing that extra $500 a month ($6000 a year) you talk about in your article, you invest in the stock market at 10%. (To make things simple, we assume that everything is done on the last day of the year.) After 1 year, you will have an extra $600 in income, taxed at 25% which means an after tax gain of $450.
You also paid an extra $360 of mortgage interest you would have not paid, had you placed that $6000 on your mortgage. However, because the mortgage interest is tax deductible, you saved $90 on your taxes which makes it effectively $270.
If my calculations are correct, you made $450 and spent $270. Of course, the stock market is more risky and thus you are bearing more risk. In a effect market, bearing risk is compensated.
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