Debtor’s Dozen

Jonathan Clements

THE GREAT RECESSION highlighted the frightening amount of debt—especially mortgage debt—that had been taken on by many American families.

A decade later, the picture is far brighter, with one exception: student loans. Since 2008’s third quarter, education debt has ballooned 144%, according to data just released by the Federal Reserve Bank of New York. But the total of all other debt—mortgages, car loans and credit card balances—is up less than 1% over the same period.

Trying to figure out whether you have too much debt—and how that debt fits into your larger financial picture? Here are 12 principles:

1. Early in our adult life, borrowing can be a rational strategy. It allows us to buy items for which we don’t currently have the cash, including college educations, homes and cars, thereby jumpstarting our financial life. But we should be careful not to take on more debt than is necessary or more than we can comfortably handle.

2. When we borrow, we borrow not from the bank or some other lender, but from our future self. We’re betting that the benefit we get from that money today will outweigh the loss of that money, plus interest, in the future.

3. We engage in mental accounting, associating the auto loan with the car and the mortgage with the house. But in truth, these loans leverage our entire financial life and increase its riskiness. Imagine we have $300,000 in stocks, a $300,000 home and a $250,000 mortgage. If stocks drop 50%, our total assets fall 25%, from $600,000 to $450,000. But factor in the mortgage and our net worth drops 43%, from $350,000 to $200,000.

4. Inflation is the friend of borrowers. As consumer prices climb, our salary typically keeps pace, but the payments on any fixed-rate loans will stay the same, allowing us to repay those debts with depreciated dollars. By contrast, inflation is the enemy of investors, especially those who own bonds with fixed interest payments. The reason: Inflation represents a permanent reduction in the purchasing power of both a bond’s principal value and the interest it pays.

5. Debt is a negative bond. When we buy a bond, others pay us interest. When we take on debt, we pay interest to others. Suppose we have $100,000 invested in bonds and a $100,000 mortgage. Arguably, our net bond position is zero.

6. Our debts typically charge us a higher interest rate than we can earn by buying bonds. Why? We aren’t considered as creditworthy as, say, the U.S. government or major corporations. Want to invest more money in bonds? Often, we can earn a higher return by paying down debt.

7. Academics talk about the risk-free rate—the investment return we can earn without taking any risk—and they usually point to Treasury bonds. But for you and me, the risk-free rate is often the sum charged by the highest-cost debt we have. Suppose we have credit card debt costing us 18% a year. That’s the risk-free rate we earn by paying down our card balance.

8. Mortgage lenders typically don’t want borrowers to take on monthly mortgage payments that devour more than 28% of pretax income. That includes not just the loan’s principal and interest payment, but also homeowner’s insurance and property taxes. Meanwhile, lenders don’t want mortgage borrowers devoting more than 36% of their income to all loan payments combined. One implication: If your student loans and car payments are snagging more than 8% of income, that could hurt your ability to buy the house you want—and you might look to trim these other debts.

9. Mortgage interest is tax deductible, but the tax savings are often less than we imagine—and there may be no tax savings at all. Suppose we’re married and our itemized deductions—including $13,000 in mortgage interest—total $26,000 in 2019. Sound impressive? Remember, we could always claim the $24,400 standard deduction for a couple filing jointly.

In other words, that $13,000 of mortgage interest is reducing our taxable income by a mere $1,600—and perhaps saving us just $352 in taxes, assuming we’re in the 22% federal income-tax bracket. The standard deduction was claimed by an estimated 88% of tax filers in 2018, which means these folks got no tax benefit from their itemized deductions, including any mortgage interest they paid.

10. We should strive to retire debt-free. That’ll reduce our retirement living expenses—and it could save us a ton in taxes. Once retired, to cover any monthly debt payments, we might need to sell winning investments in our taxable account or draw down our retirement accounts, thus boosting our taxable income. That extra income could, in turn, trigger taxes on our Social Security benefit and increase our Medicare premiums.

11. Most investment advisors have an incentive to dissuade clients from paying down debt. If clients tap their portfolio to pay down debt, that means less money for the advisor to manage—and on which to charge fees. Got an advisor who’s telling you to pay down debt? Chances are, you’ve got yourself a good one.

12. The world’s net debt position is zero. For every dollar someone owes, there’s a dollar owed to someone. In other words, if we could wave a magic wand and eliminate all debt, the world would arguably be no better off—because, for every debtor who is now debt-free, there would be a lender who’s now poorer.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Here to RetirementCalling the Shots and Cover Me. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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