MasterPo says: This blog is about topics and issues that are of importance to me. I am not one of the countless blogging lemmings that are tripping over each other scurrying down the hill and off the cliff of blogging oblivion trying to write the greatest blog on the latest topic de'jour. Your comments are welcome.

October 5, 2010

Debt vs. Cash Flow: And The Winner Is…

All forms of personal financial media are filled with articles and advise about how it is soooooooo important to pay down your debt. It is a worn out mantra.

Worn out or not, MasterPo 100% agrees with the concept. Especially high credit card and other revolving credit line debt. And even with today’s low mortgage rates owing your property outright is definitely not a bad thing!

Can’t argue against it.

But there is also a reality check that has to be considered.

Paying down debt at the exclusion of all other discretionary financial activities may not be the best approach in all cases. That is, putting every last spare dime to paying debt precludes alternatives such as making investment deposits, funding a spare cash/emergency cash account, protections such as insurance etc.

Financial planners and number crunchers are quick to offer up mathematical models they claim show the “return” on paying debt is better than most investments. This is based on the paradigm that paying off debt is the best “investment” you can make.

And it is a false paradigm.

Repaying debt is not an “investment”. Nor is it a “savings”.

Don’t jump all over MasterPo. It has already been stated in the article that repaying debt is not a bad thing.

But there is no “return” on repaying debt. Not in a practical, spendable sense. If you have a credit card at 10% interest you are not getting a 10% “return” on your money when you pay it off. Nor are you “saving” 10%. At best you are reducing your future anticipated interest payments (as well as reducing your overall indebtedness). While this does improve your cash flow it is not yet cash in your pocket until the future comes, you have the cash in hand to make the former debt payment and you don’t have to make a payment (or at least as large a payment as you otherwise would have).

A “return” implies you are receiving something of value back for what you have paid in that can be used to purchase some other product, service or investment. While reducing your indebtedness is certainly a good thing it has no spendable value. You can’t take a handful of non-indebtedness or reduced debt to the store to buy groceries. The only way to get spendable value out of debt reduction is to draw back again on your credit thereby adding back to your debt! Catch-22.

Neither is paying down debt a “savings”. You already planned to spend the money to repay the debt (presumably). If the debt is reduced or eliminated that money may be freed up to spend on something else but it is not new-found/earn money. One way or another it would have been there anyway. How you spend it – repaying debt, making purchases, investing, etc – is irrelevant. The total does not change.

Once again please make no mistake, MasterPo is not advocating against repayment of debt or becoming debt-free. Simply the single-mindedness of debt reduction has to be tempered with the realities of life.

Even if it does take longer and cost a bit more to extend debt repayment there are very practical real-world reasons for choosing not to plow everything in your pocket into debt reduction. Clearly this is open to much adjustment based on each persons’ individual needs and situation. Definitely not a one-size-fits-all approach.

But neither is blind obedience to debt reduction.


Matt Johnson said...

I agree with this entirely, especially when considering "opportunity cost."

One of the mantras in the Dave Ramsey religion is to pay down all consumer debt in "baby step 2" before you even start saving for retirement or building a serious six-month emergency fund. This includes student loans, which for some people could be close to or more than $100k. There is no exception to this baby step, even if your student loan is sitting at zero percent interest.

Of course, if you have a credit card balance eating you with a 29% APR, you won't find much better use for your money than using it to get rid of that debt as soon as possible. Otherwise, building a liquid emergency fund and building a retirement nest egg as soon as possible is almost always a good idea.

Salis Grano said...

Yes, agreed. I have an outstanding mortgage which I could pay off, but it's at 2.5% and I think I can use the money better elsewhere for now. Nine times out of ten reducing debt is the right way, but sometimes individual circumstances suggest the opposite.

Janette said...

My son borrowed 30,000 at at 1% interest (a special) four years ago and put it in a 6% /5yr CD. I got after him over it.
He is laughing all the way to the bank. The debt will be paid off from current income by the time the CD comes out.
Otherwise- we don't owe anything to anyone (except the tax man....)

MasterPo said...

Janette -

That 6% is really more like 4% after taxes (presuming a combined fed/state/local tax rate of 30%).

Take off the debt repayment and adjust for inflation (which, BTW, MasterPo does not believe for a second was zero this past two years!, but let's not digress...) and your son barely did better than breaking even, more or less.