The Optimal Way to Handle Debt

Here’s a fun finance game. Pick either prize.

Behind Door 1: A cool million bucks, packed into $1,000 bundles of crisp Hamiltons smelling of rich mahogany.

Behind Door 2: Yours truly, also smelling rich. And promising to give you $1 today. And $2 tomorrow. And $4 the next. And to continue providing double the prior day’s gift every morning for a total of 20 days. “I’m good for it,” I tell you, with a disarming wink.

What do you choose? There’s Jeopardy! music playing the background: Think fast, superstar.

Your pulse quickens. Your math-y left hemisphere lights up like the main stage at Bonnaroo. You’re thinking, “…$8 plus $16 plus $32…” You’re furiously trying to recall something your pre-algebra teacher said about daily doubling sums. You wish you’d worn your retro-hipster-ironic-cool calculator wristwatch. “Stupid iWatch!” you exclaim. You go with the cool mil.

And – facepalm – you lose about $50 grand.

That Escalated Quickly
That Escalated Quickly

Well, you didn’t really lose. Either outcome was purdy durned a’ight (as they’d say at Bonnaroo). And besides, you had limited time. You panicked. And you didn’t wear the right timepiece.

So you get a pass.

But explain this one: Why do reasonable and intelligent people still sock their financial selves in the face when in a similar situation, except with plenty of time and calculators to figure which option is better?

What I’m talking about here is debt repayment. And, specifically, the nonsensical and contorted schemes people undertake when plotting how to repay their debts.

Go Deep

Let’s just set the stage here. We Americanos love us some debt.

And, yeah, some leveraging can be a good thing. Recall the compelling arguments for investing up to 200% of your holdings in equities. That’s levered up, baby.

But the way debt tends to be used by U.S. consumers is downright nasty. There are such great mountains of credit card, auto and other consumption-oriented debt that navigating the statistics requires carabiners and rope.

  • There’s also quasi-consumption debt like mortgages and student loans that lots of households have to service. But these types of debt are arguably beneficial since mortgages enable tax benefits and can improve certain households’ portfolio profiles. And student debt carries the presumption of increased future earnings and some tax benis. So these two kinds of debt are functionally different from true consumer debt.

But they’re all part of the mix: Most U.S. households have lots of debt, and lots of types of debt. And virtually all of it carries at different interest rates with different tax consequences. None of which is all that mysterious or hard to figure out.

U.S. Household Debt Composition
U.S. Household Debt Composition

Go Shallow

So why do so many U.S. households do such a disastrous job of un-levering? Why is it so common to hear people talk about repaying debt like there’s something to it other than dollars and sense?

If you’ve got $25,000 in credit card debt on your Visa slurping up interest at a 15% APR, and you’ve got $25,000 on your MasterCard slurping up 10%, there’s no question: Pay the 15-percenter first. Entirely.

But people muck up debt repayment by focusing on other criteria instead of the numbers.

You hear stuff like: “I’m repaying my lower-APR card first because I’ve only got $10,000 on it. And I’ll get a big motivational boost when I finally pay it off! To hell with the interest accruing on my other card’s $45,000 with double the APR!”

Or: “I’ve got a 30-year mortgage at 3.2% interest, and I’m repaying it ahead of schedule because it makes me feel good to get a jump on things. I hate this super-low-cost borrowing environment, and I hate interest deductions on my taxes! By the way, I also lease a luxury SUV!”

There’s no ground-shaking analysis needed to see the blatant self-flagellation going on with stuff like this.

And there’s (almost) no overwhelmingly cool FL-styled economics gymnastics needed to prove the point.

It’s just so simple.

You should pretty much always pay off your highest-interest debt first. Pretty much.

A Little Deeper

So let’s go ahead and immortalize this truth in a snazzy summary covering the four most common types of household debt and, hell, throw in some sweet econ gymnastics for kicks and shimmies.

Credit Cards
Credit Cards (By Lotus Head from Johannesburg, Gauteng, South Africa (, via Wikimedia Commons)

Which debts should be repaid first?

1a. Credit Cards

The highest-APR debts are almost always credit cards. Not only are these by far the most expensive, they also give us zero tax benefits.

Get rid of them as quickly as possible, starting with the highest-APR card. Punto.

Just having to say this makes me want to throw some folding chairs.

1b. Auto Loans

Tied for first are auto loans. There’s no tax benefit to carrying meat crate debt. And meat crates lose value more rapidly than in-laws overstay their welcome.

So if you have meat crate debt, you need to get rid of it, no matter how low the APR seems. That’s because the nominal interest rate on auto loans vastly understates the effective, real cost of carrying the loan. This is one reason you’re better off getting rid of low-APR auto debt than repaying higher-APR student debt, or maybe even credit cards.

Let’s say you get a loan at 3% over 60 months to finance 90% of a Ford F-150’s $50,000 sticker. You’ve got a 3% loan on $45k, right? Wrong-ish.

Because the Ford depreciates at a rate of, say, 12% per year, you should really add back the depreciation loss to your carrying cost of the debt. Roughly calculated out: You’ll pay nominal interest on the loan during the first year of about $1,200. But the $45k in financed value depreciates by 12%, or by about $5,400. So, adding $5,400 to the $1,200 equals $6,600. Which implies a true cost of auto debt around 5.5x what your nominal interest rate tells you: about 16.5% during that first year!

Auto Loan: Nominal v. Effective Rate
Auto Loan: Nominal v. Effective Rate

So kill the overpriced meat crate (i.e., sell it). Get a free car if any are still left. Or, if not, get a smart econobox and kindly remind yourself that you’re too good to be defined by the kind of meat crate you drive.

Recall: People who judge you by your meat crate are miserable louses whose personal finances probably look like Freddy Krueger with a mutant strain of mumps.

Now, the above numbers are illustrative only. They’d be (much) worse for a more expensive car. Or better for a cheaper one. The point remains either way though: Leveraging up on assets that lose value magnifies the loss.

And there’s no way to win the game with auto loans. Paying them down more rapidly than needed misses the issue. The real issue is depreciation loss. And the only way to avoid that is by getting a car that’s pretty much done all the depreciation it’s gonna do. Which means inexpensive. Which means no loan should be needed in the first place.

2. Student Debt

Let’s sidestep everything but the economics of student debt at a household level. Student debt has become politically charged, but that stuff doesn’t concern us; you can find plenty of politics elsewhere.

From an econ perspective, student debt is theoretically beneficial leveraging that amplifies lifetime earnings.

Nevertheless, once you’ve got it, there’s no compelling argument to keep it.

So student debt should be repaid next. Although rates on student loans can be fairly low, and though there are tax benefits associated with student debt interest, there are a couple of problems that make it undesirable as a balance sheet lever.

First problem: student debt can follow you around after bankruptcy. Yes, you can discharge it if you pass certain tests of need. But it ain’t easy. And it ain’t a sure bet.

Second problem: holding student loans often precludes taking on different forms of debt more beneficial for wealth building – chiefly mortgages.

3. Mortgages

Which brings us to housing.

Mortgage debt is not only the very best kind of debt to obtain, it can actually be good debt. That is, it can be an extremely useful lever for long-term wealth building.

This is especially true in today’s interest rate environment.

Why? First, with mortgage rates under 4% for a 30-year fixed, you’re able to borrow a multiple of your earning power right now for next to nothing on a historical basis.

Second, the nominal rate overstates the true cost of carrying the loan.

Although I’m the first to tell you that residential real estate is a terrible investment, it’s still the case that homes tend to mildly appreciate in value. So, contrary to what we get with auto loans, there’s a reduction applicable in calculating the effective rate on a mortgage. (We’ll get back to the numerical impact of this in just a minute.)

There’s also a distortion in the housing market brought on by tax deductions on mortgage interest and by tax treatments allowing portions of housing costs to be deducted from taxable business income. The mortgage interest deduction alone can reduce the effective rate paid on mortgages by roughly one-third. Here’s a sweet calculator provided by Bankrate that illustrates.

So instead of paying the nominal 4% on your mortgage, you’re paying more like an effective 2.6%. Which is just below the 2.8% long-run real annual returns on U.S. residential real estate over the last 30 years (and well below nominal returns).

So 30-year mortgage rates at sub-4% levels pretty much mean you’re getting free money.

Free Money.

Which we like around here.

From a practical perspective, it implies the following for most homebuyers:

1) Get the longest, lowest-rate mortgage you cango for the 30-year fixed rather than suboptimal 15-year fixed or 20-year fixed or any loony variable rate garbage (unless you’re essentially a speculative investor in housing, which is totally different and falls outside the scope of this post)*;

2) Do not pay any more than the absolute minimum every month; and

3) Notice that I’m not telling you to take the largest mortgage available. Housing still should be a small part of the overall portfolio for maximum wealth because, although anticipaple returns to housing are positive, they’re small relative to other assets.

*Note: Plenty of people out there will quibble with this statement that 30-year fixed mortgages are the way to go. They’ll tell you they saved $XX,000 by switching from a 30-year to a 15-year. But they’re (probably) wrong. I’ll detail the mistake they’re making in an upcoming post about mortgage selection.

Huddle Up

Some of you are shaking your cabesas and thinking, “But I like paying down small debts early, even if they’re my least costly loans.” Or: “I don’t wanna be a mortgage-holder any longer than need be, even though lenders are giving money away.”

Eyes on the prize, Luchadores! The single greatest threat to our financial independence is our human selves.

To win the economics game, you’ve gotta subvert your lizard-brained psychology and, when the numbers are undeniable, coldly calculate like a droid. You’ve got to be super-rational about stuff like this, or you’ll miss huge opportunities for wealth generation.

Yes, there’s a place for qualitative issues in finance and economics. But not with debt repayment. The numbers are too clear.

So get to it, Luchadores!

Luchadores, do you carry any debt? If so, what’s your debt repayment plan look like?


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