Tuesday, May 12, 1998

Good vs. Bad Debt
By George Runkle (TMF Runkle)

Over the past few months in Fooldom, I've often been asked how much debt a person should carry. Should you pay off your cars before you invest? Should you pre-pay your mortgage? Should you take a 15-year instead of a 30-year mortgage? Should you pay off all your debt on credit cards before investing?

These are good questions, and I believe the answer may be different depending on your personal situation. As a rule of thumb, it's a good idea to repay aggressively any debts with an interest rate over 8%. Under 8%, it is probably better to repay the debt using the regular scheduled. Why? It has to do with the return one might expect in the stock market. Historically, the market has returned about 11% per year. However, that is over the long term, and to get that return, you have to stay invested.

If your money is pulled out of the market to save yourself a few percentage points in interest, you may miss a strong bull market like we've had in the past couple of years. You could also miss a bear market, but over a long term, you have a reasonable expectation of a premium of three percentage points over that 8% interest on the debt. This is a pretty good percentage and shouldn't be ignored.

The kinds of loans that are under 8% (other than "teaser" rates on credit cards) are generally secured. Houses, automobiles, and guaranteed education loans generally come under this category. Since the lenders have less risk, the interest rate is typically lower. Riskier credit, such as with credit cards, or the 125%"home equity" loans, carry a much higher rate. This type of higher interest credit should be paid off quickly and avoided.

In some cases, even low-interest debt can be bad. Some of us are in jobs that are subject to frequent layoffs, like the construction industry. Or, you may be nearing retirement. If your income dries up, you have to cut down on expenses. If you have loan payments to make, that's hard to do. Even if your loan is at a paltry 6%, that's little comfort if you don't have enough money to make the payments.

So, if you are 60, you may want to pre-pay your mortgage to prepare for retirement. Or, if you are a crane operator, and making lots of overtime, you may want to pay off your car loan, even if it is only 7% interest. That may be a lot easier than taking the funds out of your unemployment compensation next winter during your seasonal layoff. Again, the unpredictability of the market in the short run makes this important.

If your cash flow is only short term, your money needs to go into less risky investments. If you only have a couple years (or months) of income, you can't expect the market to always treat the money you set aside in that period well. The least risk is paying off loans, since that return is an absolute one, and probably higher than other conservative investments like t-bills or CDs.

So, to sum up, not all debt is bad. If the interest rate is low, and you don't foresee any cash flow problems for yourself in the foreseeable future, it probably isn't worth paying such debt ahead of schedule. It's more important to pay off and stay out of high-interest debt. Also, if you have cash flow problems because of unemployment, retirement, or whatever, any kind of debt can present you with a problem, and should be minimized.

(Click here for a Foolish look at paying down credit card debt.)

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