Last week we looked at interest rates and their impact on our financial accounts from the perspective of an investor. Even more common in our financial lives though, we use borrowings from the perspective of a borrower. Understanding how interest works before we are charged is imperative to avoiding the slippery slope of consumer debt that plagues many individuals. As a recap, interest is a charge on borrowed funds.
In its most simplified terms, borrowing with interest means paying back more than you borrowed. The difference is the interest paid. The lending/borrowing arrangements are incredibly diverse, but can be evaluated based on the Annual Percentage Rate of interest. UK and North American consumers are fortunate in that respect, as interest rates must be displayed in that form. This standardizes the cost of borrowing on most consumer loans by showing the annual cost of the loan. As the interest rates indicate the cost of the loan, the higher the APR, the worse the loan terms are.
The most common source of short term borrowing we see are credit cards. The interest rates on these cards are astronomically high, often ranging from low double digits all the way to 20% or more! At interest rates like these, failing to pay off your balance before interest is charged dramatically increases the cost of your purchases. Other common sources of debt are; vehicle loans, mortgages, lines of credit, store financing, to name a few.
How to deal with Debt
When paying off debt, your primary goal is to pay off anything with the highest interest rates first. This will reduce the cost of interest, and ultimately save you money in the long term. This is the mathematically best solution, and goes contrary to some other strategies. When available, you should also try to consolidate your debts into one single, lower interest rate loan. This can be especially hard to do if you already have poor credit, as banks and other lending institutions will charge you a higher interest rate to account for the extra perceived risk, or they simply may not lend anything at all.
Pro Tip: If you don’t have an emergency fund, you need a line of credit.
Getting a line of credit when you don’t need one will result in more favourable interest rates. The line of credit costs you nothing if you don’t use it, but in the event of a financial emergency, being able to pay off credit cards using a lower borrowing cost option will save you potentially tens of thousands of dollars on interest in the long run. Note: this is a last resort backup plan, and shouldn’t be utilized to finance any purchases that are not absolutely essential to living.
When to use Debt
Debt can be used for our financial benefit. We are well aware that home ownership for most of us is only attainable if we finance through a mortgage. This use of borrowed money allows us to enjoy assets that we otherwise wouldn’t be able to afford. There is one main reason to use debt, and that is leverage for an investment. Leverage simply means borrowing to purchase something. In the case of real estate, we often expect the value of our investments to increase over time, and if the gains surpass the interest costs, we come out ahead.
When to pay off debt
If you have debt, there are times when it is more advantageous to not pay off the debt. Incurring interest expenses intentionally may be the right financial move if you can make more money by investing than you would save by paying off the debt. If you can invest at a 10% return, and only pay 7% in interest, you are ahead 3%. Unfortunately the future is never certain, so you should also take a risk premium into consideration. If in the above example, the investment return under performs expectations and results in a 6% return, you would have paid more in interest than you earned.
As a result of future uncertainty, to make the equation equal you need to assign a risk premium. To display this in a formula, we would look at the decision like this:
Expected Return = Cost of Interest + Risk Premium
In the above example, we can use the 7% interest and a 2% Risk Premium. If our expected return exceeds 9%, we are comfortable taking the risk for the extra returns. If the expected return is less than 9%, we should pay off the debt for the guaranteed cost savings of 7% in interest charges.
Take-Aways
Borrowing money is an important part of our personal finance journey. Understanding when and how to use debt, and how to evaluate different options will ensure we make the right choices on our path to financial freedom. Some of the key take-aways from this article are:
- The higher the APR, or Annual Percentage Rate, the more interest you will be paying, and by consequence, the worse the debt is.
- Paying off the highest interest rate debt first will save you the most money.
- If you don’t have an emergency fund, get a line of credit before you need one. Your terms will be better, and in case of an emergency, those better terms can help keep you from financial ruin.
- Use borrowings to invest in assets that will increase in value. This is called leverage.
- Pay off debt first unless the investment return is more than the interest rate on debt plus a Risk Premium that suits your investor type.