Finance, Investing

What’s Your Cost of Debt? 

 

First off, apologies for my long-ish hiatus. No excuse! So, I will get the juices flowing by starting off with something that is, mathematically, elementary.

 

INVESTING AND CARRYING A CREDIT CARD DEBT BALANCE IS LUNACY.

 

This statement rings true in most scenarios and has few exceptions. I will begin with the most common exception: investing in a 401(k) or other tax-advantaged retirement account if your employer matches contributions.

401(k) investing is done pre-tax, whereas most other forms of investment occur after Uncle Sam has already whittled your dollar down. This alone conveys a gigantic advantage to your nest egg, as it compounds tax-free for decades. Employer matching of 3-6% is fairly typical here in the U.S. and unless you’re truly in dire straights, you should at a minimum contribute the minimum to your 401(k) to maximize the employer matching.

 

Employer 401(k) matching is an immediate 100% return! Get after that shit.

 

Maxing out your 401(k) contribution to at least equal the employer matching amount is not a revolutionary concept. I’m sure you’re all yawning.

When you invest, you need to keep a minimum return, or hurdle rate, that is required to earn your financial freedom. A good rule of thumb is at least a 7% annual nominal return (not inflation adjusted). Warren Buffett has a hurdle rate of 15%. You and I are not him, however, and 7% is a realistic expectation long term from a passive investing strategy using mutual funds and ETFs.

Does employer matching clear the 7% hurdle rate? At 100% return (at least initially), it SMOKES it. So do it.

How about credit card debt? Unless your weighted average interest rate (cost of debt) is less than 7% (liar), you need to pay off those credit cards before you think about investing another dime.

Let’s say you have 4 credit cards with the following balances and interest rates:

Credit Card 1: $4,000, 14% interest

Credit Card 2: $3,500, 19% interest

Credit Card 3: $1,250, 23% interest

Credit Card 4: $700, 17% interest

Credit cards here will be represented with “CCx”, where x is the number. Interest rates are “rx”, with x again being the corresponding number. The formula for your “cost of debt” is this:

Cost of Debt (CoD) = ((CC1*r1)+(CC2*r2)+(CC3*r3)+(CC4*r4)) / sum of all credit card debt
This comes out to:

CoD = (560+665+287.5+119) / (4000+3500+1250+700) = 1631.5 / 9450 = 0.1726 or 17.3%,

Your hurdle rate for investing is now AT LEAST 17.3%. If you can do that consistently over time, you will be one of the wealthiest people on the planet. However, realistically, that’s way more than you’re likely to achieve. This exceeds the 7% reasonable assumption significantly.

Your 401(k) matching return is 100%, which trounces this cost of debt. Keep contributing to that. However, any spare penny should be used to knock down this malignant debt.

I just watched “Alien: Covenant” and a good analogy (or simile if you’re trying to snipe me) is that debt is like the alien’s acidic blood. It is corrosive to your well being! Get that acid off your face and live your life with less stress knowing that your future is significantly better off. If a 17% compounded return annually would make you a very rich individual, a 17% compounded loss annually will melt your face off.


By the way, this formula can be applied to ALL your debt. Student loans, car loans, mortgages…throw all of it in there. However, if your only debt is a 2.5% mortgage…consider maxing out your 401(k) and additional investments before knocking that down. At the very least, it is not the emergency that higher interest debt is. If your debt is a 7.25% grad school loan (ME), it is slightly higher than your hurdle rate so consider making extra payments to accelerate the payoff time (I do).

Personally, I LOATHE debt because it makes me feel like an indentured servant. Aside from retirement accounts, cash, and precious metals, I do not actively invest in the stock market and I will not until I pay off all forms of debt. Your situation and outlook may be different than mine. This calculation serves as a rational starting point. My loathing overrides pure logic.

Big caveat here: keep your loan debt and revolving debt (credit cards) separate in this equation though. If you have a million dollar mortgage at 3.5% and some credit card debt as well, the mortgage amount is likely to weigh so heavily in the equation that your overall Cost of Debt is below your hurdle rate.
Aside from alien acid blood, what else is debt like?
*Note: For further reading, please see my earlier posts on your money multiple and deciding to invest in individual stocks. I’m structuring all this to build upon itself.

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