Debt
I have it and you likely have it to. Managing your debt load on your personal finances is something that always should receive attention to minimize your interest paid as well as risk of getting into serious financial trouble. This post summarizes some things I have learned over time a out managing our family’s debt.
Debt Is An Accelerator When Used Effectively
Being a finance professional in real life – I like using debt to accomplish financial objectives to grow a business. I also like debt for our personal finances. Instead of being scared of debt, over the years I have learned to embrace it. Eg our approach is “how are we managing debt vs omg so much debt!”
Most people think of Debt as an enabler of traditional items: debt has helped us buy a house with a payment that was lower than what we were paying for rent prior (my imputed “rent” now goes to the bank vs. the “landlord”), get an advanced degree, and buy a car with lower interest rates, and eventually will help us build out our portfolio even further.
But the same enabler capabilities to buy “stuff” can be extended to investments. This is what many real estate professionals do who built up a rental property portfolio.
Debt Is An Accelerator – Example Math
Let’s get out our calculator and prove out that debt can accelerate even small investments.
Scenario 1: $10,000 to invest at 3%. The result is $304 of income over 12 months.
Scenario 2: $10,000 to invest at 3% but we took out a loan at 6% for $5000. This gives us $15,000 to invest at 3%. $306 of income over 12 months…. more income! If you can boost your yield or lower your interest rate this amplifies further.
Debt Is An Accelerator – Key Take Away
Math proves out you can accelerate your gains when you lever up an existing investment and your at risk principal vs. debt ratio makes sense. This is why leverage makes sense for businesses that generate cash flow – whether it be a rental property, an investment portfolio, or a larger business.
Debt As a Wealth Destroyer – Example Math
What I have to remind myself about often is the fact that this math doesn’t hold true when you try to “Bring Forward” income. This is where most people fall into a debt trap and math helps prove out that even income generating portfolios can be hampered by trying to bring forward investment with leverage.
Scenario 3: $10,000 to invest at 3% but we know it will take us time to built up the portfolio. Assuming you can save $1K a month you eventually generate $189 of income over 12 months.
Scenario 4: Let’s say I wanted to bring this investment forward as I want to make the investment now and start with my $10,000 right out of the gate and invest at 3% and paid down debt over time. Assume we took out a loan at 6% for $9,000 up front. Net result $22 of income over 12 months…. less income than scenario 3!
The Interest Rate Paid on Debt is a Reverse Investment
The interest rate paid on any debt is essentially the equivalent of the paying out interest to someone else. Or said another way – you are either earning the interest or someone else is. This is arbitrage 101 but it is an important lesson for personal finance.
There ultimately is a tipping point for any leverage equation and you really need to pull out the calculator to determine where that is for your specific investment.
To illustrate – the below is a data table that takes leverage across the left side (Assumes 6% interest rate on the leverage) and cash flow yield across the top (ties to the 3% example we were using above). As you can see from the chart the tipping point for this investment mix is 50% leverage (51% to be exact) and earning 4% on cash flow investment. This is the tipping point where the net cash flow coming in (interest minus debt service) is equal to if we just invested at 3% to begin with and took out no leverage.
Last But Not Least – Taxes
Taxes are a real cost. If your cash flow stream will be taxed, you should reduce any analysis by that tax rate. Similarly, if your debt has a tax shield, that also should be accounted for.
Some Final Thoughts on My Debt Math Excercise
I stare at my finances way too much which results in me pulling out spreadsheets like you see attached to remind me what the math implies is true. As we have journeyed through our personal finance journey I have learned the following about debt which links up to the items above:
- Debt is a useful accelerator for key areas in life – example a house
- Interest goes somewhere – either in your pocket or the banker. Interest rates you pay out should be as low as possible for that reason. Interest coming in should be high as possible.
- Taxes have absolutely influenced some decisions we have made on debt vs. investments. When factoring in taxes, most financial decisions will point you to paying down the debt.
- Leverage on an investment portfolio, rental property, or other cash flow investment can be advantageous but it is important to know where the tipping point is for your specific circumstances
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