Thursday, March 6, 2008

Managing debt

I grew up thinking that debt was a bad thing. Why buy a car when you can't afford it outright? I understood that houses required mortgages, but why put things on credit cards when you can pay cash? Managed properly, debt, even in credit card form, can be a good thing.

Spending

A lot of proper debt management depends on a realistic assessment of your spending habits. I, for example, don't tend to buy things. Or, I didn't until I bought a house and needed to put things in it. I have no expensive hobbies (compared to my brother who buys guitars and related equipment quite often) and I keep my monthly spending constant within a couple hundred dollars, in general.

In short, my spending habits are well defined and I track them informally. I also have a pretty stable job. IBM is a $160B company and people seem to like what I do there. Thus, I have a demonstrated discipline when it comes to spending and a pretty solid income. The risk of me not being able to pay my monthly bills is fairly low, so debt shouldn't be an undue emotional burden.

Interest Rates

The rest of debt management is interest rates. Most debt is pretty simple, actually. The interest rate is advertised directly. Some interest is tax deductible, though, in which case you need to multiply the advertised interest rate by (1 - your tax rate). For example, if you're in the 25% tax bracket and have a 6% mortgage, you're effectively only paying 4.5%.

If you can beat the interest rate determined above through investing, you can actually make money by going into debt. Even with the recent downturn, The S&P500 index has seen annualized growth of 9.516% over the last 5 years. That pesky tax rate works against us a bit, here, though. Interest income and short term capital gains are taxed as regular income, while long term capital gains are taxed at a 15% flat rate. For a worst case scenario, we can assume everything will be taxed as regular income. We need to now divide our effective interest rate from above by (1 - your tax rate) to get an rate of return goal. That 4.5% becomes 6% again. An 18% credit card interest rate becomes a 24% goal. Whatever we invest in, we need to beat this final rate in order for the debt to be profitable.

Over the long term, an 8% annualized return is fairly achievable. If you can invest money borrowed at 6% (effective) or lower, it is likely that you will be able to make money on money you don't actually have. This whole argument only applies if you have the money available to invest, though. If you borrow money to buy things, then that money isn't working for you.

Credit Cards

When there is something you need to buy, credit card debt can still be a good thing (even a card with an 18% interest rate!). The key is to not keep an interest-bearing balance. Pay the credit card off completely each month and you've basically borrowed money for 30-50 days interest free. You can keep that money in a high interest savings account and earn an extra few dollars by using a credit card instead of cash. Even better, you can get a credit card with additional cash back like the Chase Freedom card and/or Citi Dividends card.

Keep in mind that interest-free financing isn't a free pass to go on a spending spree. You still have to pay the purchase price. However, a store's 0% financing credit line can actually be better than cash back credit cards. I'll leave it as an exercise for the reader to determine a formula based on bank account savings rate, b, financing period, t, and cash back bonus, c, that calculates the break-even surface.

1 comment:

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