We’ve all heard the stories of people who have gotten out of debt and how wonderful it is. Dave Ramsey has made the “freeeeeedommmmmm” yell standard for his listeners who have eliminated all their debt.
And yet the debate rages — is it wise to pay off all your debt or not? There are arguments on both sides.
This post is designed to address one aspect of the debt issue — the cost of debt. Many people know that it’s expensive but they don’t really tally up the numbers. That’s what I hope to do here.
And for those of you who don’t know, I’ve been debt free for 20 years or so (other than my recent house purchase where I needed to take a short-term loan because my previous house hadn’t sold yet).
The Cost of Debt
Let’s begin with this post from Money Magazine piece titled You’re Going to Spend $280,000 on Interest in Your Lifetime. The highlights:
The typical American consumer will fork over an average of $279,002 in interest payments during the course of his or her lifetime. So says a new report from Credit.com, which analyzed the lifetime cost of debt in all 50 states and the District of Columbia, based on average mortgage balances, credit card debt, and credit scores.
The size of the nut varies dramatically from state to state. Residents of Washington, D.C.—where average new mortgages are $462,000 and the average credit score of 656 falls squarely in the “fair” range—can expect to pay $451,890 in interest, the highest in the nation.
Concerned D.C. residents might want to consider hitching a ride to Iowa, where the average new mortgage is the nation’s lowest, at $120,467. Add in an average credit card debt of $2,935—also the lowest in the country—and a credit score of 689, and residents of the Hawkeye State have a lifetime cost of debt of “only” $129,394.
As someone who grew up in Iowa I had to smile. The reason there’s low debt in Iowa is because there’s nothing worth buying in Iowa! Ha! (Ok those of you from Iowa, don’t shout me down — I’m just kidding. I love Iowa, still consider it “home”, and my parents still live there, so settle down and take a chill pill.) 🙂
Let’s discuss this a bit before we move on:
- That’s a wide range from DC to Iowa and proves the exact point I was making in Become Wealthy by Having a High Income in a Low Cost City.
- $280k isn’t as bad as I thought it would be. I’ve seen debt costing as high as $600k over a lifetime.
- The credit score really makes a difference. I put 689 into an online calculator and you pay 0.4% more with that score versus the top group score of 740+. The difference is roughly $15k over the life of a 30-year mortgage, not to mention additional costs for car loans, etc.
- On a personal note, I’ve lived in the #1 (for a summer) and #10 (now) top 10 states with the highest cost of debt but also the #1 (growing up) and #8 (for 5 years) top 10 states with the lowest cost of debt.
Debt Costs Millions
Now let’s dig into the cost of debt itself. Go with me along this path:
- The average person pays $280k in interest in his lifetime.
- If he hadn’t borrowed, he would have never spent $280k and could have invested it instead.
- Over 40 years, that’s equivalent to an extra $7k per year.
- Let’s say we invested $7k per year for 40 years at 8%. That adds up to almost $2 million!!!!! Yep, read it and weep.
Debt Costs Hundreds of Thousands
But that’s a bit overboard, right? EVERYONE borrows something for some time. I paid off everything in my 30’s and still borrowed for a decade or so. So let’s assume that a person has to borrow some, but pays it off in 20 years, saving $140k.
$140k over $20 years breaks down to $7k per year (of course). $7k for 20 years at 8% is almost $350k. Still, not bad. Most people could do a lot with an extra $350k.
One more time. Let’s say you follow my plan and pay off your mortgage (and everything else) in 10 years. That leaves you 30 years at $7k per year at 8%. That’s over $850k!
Yes, the numbers may be off a bit but if anything they would be better. By paying off debt early you avoid interest over a long period of time, saving you way more than simply taking a fraction of the total. But it’s close enough and directionally correct.
So let’s all agree that debt costs you a ton.
Investing Versus Paying Off Debt
Now I can hear a bunch of voices saying they can borrow at one rate and invest at a higher rate, so debt pays for itself.
In theory this may be true. I understand this intellectually, but consider the following:
- Paying off debt is a guaranteed return. Investing at a higher rate is not.
- Investing starts small (like with $1,000 at a time) while debt is large from the get-go ($200k mortgage). Earning 8% on $1,000 is way lower than paying 4% on $200k.
- The freedom factor. Good feeling.
- The retire early factor. Know how many people I’ve met who said they would like to retire but can’t because of their mortgage? A ton. I could not have retired as early as I did if I had a large mortgage payment hanging over my head.
- The vast majority of people do not have the discipline to keep debt and use it to fund investments. Instead of “investing the difference” by keeping debt most will “spend the difference”. I’ve seen it over and over again.
If you want a well-thought-out response to this issue, see Apex’s comment on 15-year versus 30-year mortgages.
How about this as a balance: save up your money and invest it. Let it grow, then buy a house by using a large downpayment and make extra payments to get rid of the debt within 10 years?
Of course, if you grow your income as I recommend, you can do both. While we were paying of our house, I maxed out my 401k contributions every year. Yes, you can invest AND eliminate debt.
Thoughts?
Back in 2009 I resigned from my job rather suddenly (it was either resign or most likely be fired). I was flying high in a six figure job and buying up rental properties as fast as I could close on them, relying heavily on leverage. Losing my primary source of income was a real wake-up call. Since then, I have focused on paying off debt. Having a lot of debt is a huge source of stress for me, even the kind of debt that supposedly produces income. So, I’ve gone from over $500,000 in debt to closer to $100,000. Only one of my properties has a mortgage now. I downsized my life, paid cash for a small, foreclosed home in which I live, and focused on simplifying my finances. While I’m still not where I want to be, I am at a point now where I no longer have to worry about my finances. The best part? It feels SO GOOD to not have that debt cloud hanging over me. I’m snowballing most of the free cash flow into paying down what’s left, but I have freed up so much cash that we now are taking dream vacations: this summer we cruised the Mediterranean; next summer we visit Iceland. The crazy part? My income from work is half what it was before 2009.
Excellent analysis and scary to think people pay so much in interest (myself included).
I agree with your approach to pay down a mortgage as rapidly as possible. I think for most people, that approach puts them in an exciting scenario to save as much as they can. Once we’re motivated to save, it doesn’t matter if the return on our savings is 5% or 8%, as long as we’re boosting our savings rate rapidly. The unique factor here is the tangible benefit to owning a home at the end of the loan.
The only thing I’ll add now is on the subject of student loans. I’m a big advocate of maxing out pre-tax retirement accounts BEFORE putting EXTRA money into the loans (assuming they’re at 5% or 6% which is what I often hear. If they’re higher then refinance).
The two things that sold me are not on your list so I thought I would add them here. The first is you develop a habit even at 21 or 22 to start investing and saving some of your money. That habit will still be there once you have the loans paid off and its hard to stop investing. The alternative, to live a spartan lifestyle and pay down debt, means total freedom earlier, but I’ve also seen friends then slip immediately intro credit card debt since they “finally decided to splurge”.
The 2nd is the tax savings. Pre-tax immediately means 20%+ return that could be made 95%+ permanent if we retire early and utilize a IRA conversion ladder.
Based on this approach, I was able to increase my net worth by an extra $7,000 in 2015 alone, so you can see why I’m a big advocate of this approach when it comes specifically to student loans.
Now that our income has grown, we’re looking forward to applying the both approach that you were able to do as well.
Great review of debt and thanks for putting the article together!
You are absolutely correct. Debt interest will eat you alive. Your house payment for the first years of a thirty year mortgage is mostly interest. It takes years to reduce the principle. It is even worse for student loans because many of them have variable interest rates. If you begin to pay the principal down–the lenders jack up the interest rate to retain the loan and keep making you in debt. Debt is voluntary servitude.
Like you, I’ve been debt free for 20 years. I rented and the first place I bought (overseas) I paid cash for. It’s basically a waste of money and in today’s world where expectations of investment growth are low (I would seriously challenge 8% returns when the 10 year treasury is so low) paying off a 5% interest rate is almost a no brainer.
-Mike
It’s funny how assumptions for return rates have varied over the years.
When I started blogging there were high returns so assuming 10% was fine.
Then the markets looked a little weak and I got pushback for using 10% so I started using 8%.
Now 8% might be aggressive so perhaps I’ll go to 6%.
If we do go to 6%:
*Paying off debt looks even better as the gap between paying versus investing narrows.
*The value of paying off debt and investing afterwards goes down.
FYI, I think I saw something the other day where Dave Ramsey still uses 12% as a return rate.
Interest on credit cards, on TVs, Furniture, etc is pure loss to early consumption.
However debt on mortgages is very different.
First it is tax deductible but I am not even going to talk about that. You have to live somewhere so the cost of a mortgage is not pure loss to consumption like buying TVs is. It is mostly just replacement for rent.
For instance. Lets say you can rent a 2 bedroom apartment for $1000 per month. Instead you buy a 3 bedroom home and have a $1500 per month mortgage payment (with taxes and insurance). The $1000 rent is a total loss. Of the $1,500 mortgage payment about $250 will be principal on a 30 year mortgage. So $1,250 will be lost to interest, taxes, and insurance (In this example first month interest is about $1000, the same as rent, but will go down each month. Total interest paid over 30 years would be $300K).
So the difference here is a cost of an extra $250 per month in pure loss by owning the home and paying the mortgage (I am ignoring maintenance which is also an added cost to owning). However this loss will go down each month as more and more principal is paid.
And in fact in this case the person has upgraded their living space from a 2 bedroom apartment to a 3 bedroom house with probably double the square footage. If they had instead actually purchased a house that was truly comparable in size to the apartment they could likely have done so for less than the cost of the apartment in the current low interest rate environment.
Now certainly paying this debt down faster can still be prudent but when talking about the total interest paid it is not like the 300K in interest could have been avoided. Without the mortgage you would have actually paid 360K in rent over 30 years if rent was never raised but we know rent goes up while your interest payment actually goes down. Mortgage interest is mostly a replacement for rent and as such is not really an extra cost. It is simply moving the cost from rent to interest. For those who own for 30 years and continue to pay down the debt even at the minimum payment after accounting for interest, taxes, insurance etc, you will likely come out about the same as if you rented and you will have a slightly larger place. If you bought a place of comparable size you should actually come out ahead after all the mortgage payments. If you can’t come out ahead doing that then all investors would have to lose money long term. They won’t do that, they will raise rents or get out, so long term you should come out ahead even by having a mortgage for 30 years on property you own.
None of that means you can’t come out more ahead by paying the mortgage off early, but the main point I want to make is that the 300K is not money you could just put in your pocket. It is simply a replacement for rent. You can’t actually have that money. You have to pay it as a cost to live either in rent or interest.
P.S. – It’s worth nothing that if you pay it off early you are simply doing a different form of saving. A renter could do the same by saving the amount that you are using to pay debt off early and investing it. Both take discipline. Either one is a viable means of getting ahead. It’s not this kind of debt (mortgage) or the interest that ruins your finances. It’s the spending of the extra. If you have the ability to pay down debt early you had the ability to save the extra if you were renting because again, the debt is not a new expense, it is simply a replacement for rent. You have to pay one of those costs unless you want to live in your van down by the river.
Ha, ha, your comments on Iowa. I too grew up there and still visit my mom there. Our first house was in Iowa and the closing costs were very low. When we moved to the mid-Atlantic region there were so many more closing costs associated with buying a house.
We have been debt free for about thirteen years and I wouldn’t trade it. When you’re paying actual cash instead of a monthly payment you feel the brunt of major purchases. When we bought my daughter a late model used car a couple years ago the first paperwork they handed us was for financing. I quickly told them I had our checkbook with me and the purchase would be cash.
Not having a mortgage is so freeing. It’s wonderful to not worry about making payments and knowing that we could coast for a long time if something happened. We do not live in the largest nor fanciest house but I’m more than content with what we have, free and clear.
Funny how when you pay your mortgage off you want to tell the world and in the next breath you don’t because you are a freak in your friends eyes. I paid off a $129K mortgage in 12 years and I felt the freedom and these feeling. When I had a discussion with a friend who said that was stupid and that extra money should be invested in the market. I asked him… so if you lost your job how long could you live without another job with all your bills including that mortgage and what you have in savings before you have to start tapping into that money invested in the market at a loss that would have paid off our house probably because the economy is in the toilet and that was the reason you lost your job. ( sorry for the runn on sentence)
He looked at me and saw my point.
Get out of deep debt as fast as you can and then start investing the rest… Contrary to what anyone tells you…
Great post ESI, the cost of debt is huge and most people don’t even realize it. We haven’t had any non-mortgage debt in decades and are currently on a path to have our home paid off in nine years. If I wasn’t maxing out my 401k and HSA accounts, we could do it sooner.
To your point in the article, if it wasn’t for the mortgage, I could probably retire now! (almost…)
Iowan here! Generally speaking the col here is relatively low. But we live in one of the highest col areas in the state, where I can drive down the road to houses currently being built for $500,000 – $900,000!
Great post on the high cost of debt, ESI! We still have a mortgage (no other debt) – and it’s an ongoing debate in our house as to whether we should focus on paying it off or invest the money (and you’re right – we could do both!). At an interest rate of 3.25%, the numbers tell us to invest, but numbers aren’t everything. There’s peace of mind in being completely debt free.
Maybe there’s a compromise – e.g., if you have $1,000 extra a month, go halves?
That’s actually what we did — both.
If you grow your income enough, you can pay off debt AND save/invest the entire time you’re doing it. We fully funded my 401k during the time we paid off debt.
This is yet another reason I write so much about growing your income — it just gives you so many more options.
Another great read, ESI, really like your writing.
As a younger person starting out in the ’80s, carrying debt was quite accepted and inflation offset quite a bit of the interest costs. Today, I’m seeing deflation (yes, yes, the official CPI blah, blah, blah).
Make your choice early, and live with it. So many of my contemporaries from school cry about it, because 30 years later their ‘ship didn’t come in’. Don’t be one who has to smile through the tears when you hit your 50s!:-)
Also, really like ESI (and other posters) talking about mortgage debt. ESI’s recommended book ‘Millionaire Next Door’ advises, “buy your second house first.”
ESI, I’m a little new to your blog so if I haven’t found this yet please point me in the right direction.
The other issue to consider with mortgages, specifically 30 year ones, is that the interest is front loaded. So that loan may be for 5% but you’re going to pay most of that 30 years worth of interest at 5% in the first 15 years. On a $200k mortgage at 5% you’ll pay $130k in interest in the first 15 years and only about $56k the second 15.
Is it worth paying early a mortgage with only 2,19% fix interest rate over 23 years?
This is what we got last year on a 150K€ mortgage.
That’s an on-going debate.
You can read about the options here:
https://esimoney.com/deciding-the-pay-down-mortgage-or-invest-debate/