Debt Is a Beast


Debt is the ultimate anti-asset. It’s kryptonite to any early retirement dreams you might have, and applied in large enough doses, it can keep you from ever escaping a paycheck to paycheck, income-based life.

Everyone knows that debt is dreadful, but fully understanding how truly bad it is a 3 step process.

1. Debt is an Outflow

This one is obvious. Paying money to someone else is taking away from your own pile. Debt is a stone around your neck in the race to retirement.

By taking on debt, you’ve bought something with money you don’t have. That is generally a bad thing, but of course some things, like houses, would be hard to buy without debt. Debt is a good servant but a terrible master: use it wisely and sparingly, and never forget it’s taking you in the wrong direction.

2. Debt is More Expensive Than You Think

Most forms of debt are paid with after-tax dollars. You make money, pay taxes, and then, with what’s left over, you pay for your debt.

Since your assets earn a return that is then taxed (you earn a “pre-tax” return on them), you can’t directly compare asset % returns and debt % costs.

The first step in understanding how much debt is costing you is to determine your marginal tax rate – the tax rate applied to your last dollar of earnings. You can find your 2014 marginal tax rate here.

Suppose you are married filing jointly, and you have taxable income of $100,000. For 2014 your marginal tax rate is 25% – that doesn’t mean that you pay $25K in taxes; it means that if you earned one extra dollar you’d pay 25 cents of tax on that dollar.

So with a marginal tax rate of 25%, let’s say you have a car loan at 3%. What type of investment is paying off this debt? A 4% pre-tax return: your 3% debt rate / (1 – your marginal tax rate of 25%).  Said another way, you would need to find an asset that paid you 4% to give you a 3% after-tax return (4% less 25% in taxes).

How about some credit card debt at 15%? With a 25% marginal tax rate, paying that off is like an asset that returns 20% pre-tax.

Mortgages and student loan debt do have tax advantages, so the calculation isn’t the same for them. At their best, their stated rates can be directly compared to a pre-tax asset return, but their tax advantages are not as straightforward as you might think.

If you have a truckload of student debt, there’s a good chance some of it isn’t getting any tax benefit. And if you make too much money, all of your student loan interest is after-tax. The current limitations on student loan interest are described here.

Your mortgage interest must be included as an itemized deduction on your tax return for you to get its tax benefits, so it needs to compete, at low levels, against your standard deduction. At high levels, it is subject to being phased out and also can be reduced through adjustments to your Alternative Minimum Tax calculation. Plus, if you’re paying an extraordinarily high level of mortgage interest, you’ve probably got too much house…

Mortgage interest is arguably the best type of debt to have, but being the least bad of the bunch isn’t the same as being a wonderful thing.

You don’t need to update your marginal tax rate and break out a slide rule every time you want to calculate the true return of paying off debt – just know that most debt costs you even more than the stated rate, which makes paying it off an even more attractive investment.


3. Debt Never Has an Off Year

Different asset classes earn wildly different returns. “Risk-free” assets, like U.S. government bonds, typically pay the lowest return, because they’re, well, risk-free. People don’t demand a lofty return because they see little risk in these types of assets (in a pinch the U.S. government could even print money to make its payments).

Assets with greater risks typically have correspondingly higher returns. For example, the only reason you’d invest in a company’s debt over U.S. government debt is if they pay you more for doing so.

Over (sometimes a very long) time, stocks have historically had much higher returns than risk-free assets. This high return – in the neighborhood of 9 to 10% over long stretches – is due to stocks being much riskier assets; investors demand a significant risk premium to hold them. But in any given year, the stock market could see huge losses, and holding stocks is sure to be a roller coaster.

You can think of risk as the chance that an investment will have a different return than you’re expecting. You might expect your stocks to return 9% every year, so the year they drop by 40% highlights their risk.

Good News: Debt is Low-Risk! Bad News: It’s an Outflow…

So what kind of risk does your debt have? Very little. It’s far more predictable than the stock market, at least as long as you pay what’s required. There is the slight problem that it’s a negative return, but that negative return is pretty darn steady.

Rain or shine, good times or bad, your debt demands to be fed a constant, highly predictable stream of money. You may argue that you do have some choices: you can miss a payment, or even walk on your obligation altogether (bankruptcy, repossession, foreclosure). While that’s true, those types of events are unmitigated disasters in the quest for an asset-based life – you’re going back to the starting line or worse. The rosiest picture of debt you can have is an unstoppable, voracious beast with a steady appetite and its mouth in your paycheck and wallet. It just gets worse from there.

Paying Off Your Debt – The Best Risk-Free Return You’ll Find

Since paying off debt offers virtually risk-free returns, it’s suddenly an attractive option even when compared against investing in the stock market. The stock market may have higher expected returns, but it is much more volatile and therefore risky.

Certainly, if you were a risk-neutral robot with an infinite time horizon, investing in stocks while still holding debt with a cost just below your expected stock market return might make sense. But as a human with a shorter time horizon, the risk-free return from paying off debt makes it one of the best investments you could possibly have. If someone could offer me an 8% guaranteed annual return for all my money, I’d be happy to never invest in stocks again.

In addition, most people don’t and shouldn’t have 100% of their assets in stocks. If you have some money in less risky assets classes (e.g., money-markets, CD’s, short-term bonds) for an emergency fund, then paying off debt becomes even more compelling. Paying off debt will always offer better returns than assets with similar risk. And as you pay off your debt, your need for an emergency fund goes down too.

There are a couple of key caveats to a general rule to pay off all debt ASAP:

  • Tax-advantaged debt like a mortgage is not as clear cut – there are a number of complexities that need to be considered in that decision, and it’ll often make sense to keep this in place while you start building your asset base
  • Some assets offer extraordinary returns and should be prioritized. The best example is taking full advantage of any matching your company does for your 401K. This is an instant return (at some firms to the tune of 50 or 100%). Paying off debt can’t compete with that, but those types of opportunities are typically limited.
  • You need to have enough discipline to immediately start massive savings, especially in tax-advantaged vehicles (401K, IRA, Roth IRA, etc.), after paying off your debt. Step one is get the stone from around your next, and step two is to immediately build a huge pile of assets.

Debt is the bane of an asset-based life. If you have it – especially credit card debt, other consumer debt, car loans or leases – get rid of it. If you don’t have it, never get it.

Everyone knows debt is bad, but the full story: it’s a steady, voracious, “risk-free” beast that costs even more than you might think – shows why paying it off is such an incredible investment opportunity.



2 thoughts on “Debt Is a Beast”

  1. Excellent article – I could not agree more. Debt is more than a personal balance sheet issue, it is a limitation. Life is liberating when you can save and make decisions without thinking “I need to pay the bank.” This article does a great job of explaining why debt is weakness and why it should be paid off as quickly as reasonably possible. Thanks for writing this!

    1. Thanks for the note! Yep – it’s always over your shoulder, just waiting for you to trip up. A lot of folks forget the “risk-free” aspect of debt – it just grinds along, sure and steady. Losing that limitation is liberating indeed!

Leave a Comment

Your email address will not be published. Required fields are marked *