A quick story on why this post is particularly important to me.
In the not so distant past (about 6.5 years ago, damn I am getting old) I graduated from college. Along with my diplomas (MBA immediately after undergrad) was a fricken stack of Student Loan bills. When I say stack I mean it. I had 5 different servicers that required monthly payments.
At the end of 2012, when I was filling out my tax return I was excited to see the Student Loan interest could be deducted! That excitement quickly faded when I saw the limit was $2,500 and I had paid a WHOPPING $5,000 in Student Loan interest.
I wasn’t making much money, and we could have used that $5,000.
Instead, it was basically set on fire. When you are hurting for cash, realizing you are wasting so much money is a powerful motivator.
At that point, we decided to start reading about paying off debt and ultimately taking action.
What is your Debt Costing you?
I break the cost of debt into two big camps:
- What is that actual cost of your debt?
- What is the opportunity cost of your debt?
I think it is beneficial to look at both of these items to truly understand the cost of debt.
What is the actual cost of your debt?
We are busy, and when that bill comes in the mail every month we look at the short-term cost of debt.
“How much do I have to pay right now?”
Understandable reaction. We like to know how things affect us immediately. But I challenge you to look at the bigger picture. What we should be asking is:
“How much is this debt costing me over the life of the loan?”
In small increments, the cost of debt doesn’t seem all that bad. Maybe $50, $100 or even $200 a month doesn’t raise any red flags. Looking at the total cost of debt is a completely different story.
Check out the 3 examples below. It shows the impact of different loan types with common interest rates.
Example 1: Car Payment
Using our own car loan as an example
We scored a pretty awesome interest rate when we bought our car a few years ago (before our full financial enlightenment). Buy when the dealers are desperate I guess.
At the end of our 5-year term, this loan will cost $541.53. Not all that bad for a 5-year loan.
Example 2: Student Loans
Linking back up to the intro story, I refinanced* my student loans after paying about 50% of my balance. At the time of my refi, I still owed $44,437. Even when making payments over $800 every month the remainder of my loan would still cost $4,4743 if we made minimum payments.
The cash flow loss bothers me more than the interest rate, but that is still a $1,000/year that you could put to better use.
I refinanced my student loans and was able to drop my interest rate by over 2% saving us thousands of dollars. SoFi is the company I personally used – awesome rate, awesome experience. I will make money if you refinance with SoFi but wouldn’t recommend them if I didn’t love them myself (you will also get a $100 welcome bonus)
Example 3: Credit Card
Thankfully, we don’t have a lot of experience with Credit Card interest rates. They are destructive, to say the least. 15-23% interest rates are not out of the ordinary.
To put that in perspective the stock market averages approximately 8-9% if you are invested long term. Credit Card companies are doubling that. It is a criminal charge that needs to be avoided. If you have credit card debt it should be the first thing you attack when pursuing Financial Independence.
A $10,000 credit card bill, making minimum payments will cost $14,423 and take 28 years. Yeeesh. No wonder it is so hard to break the cycle once you get in too deep. Paying almost 150% of the original balance!
Interest + 1% is a common method for determining minimum payments
Action Item: Go to the debt tab of the FI Action Series Spreadsheet and figure out what your debt is going to cost you over the life of the loan. Don’t cry. We will take care of it later.
What is the opportunity cost of your debt?
If we want to look at the true cost of debt, we need to think about the opportunity cost of the money you are paying in interest.
Related: Should you invest or pay off debt?
Every penny that you pay in interest could make a HUGE impact if you invested it long term. An example from a recent post: Can you do 1% better?
If you put $500 extra a year away (which is well below what you could save in the credit card example above), you could end up with over a $135,000 in 40 years. That assumes an 8% return, but that is below the long-term average stock market return.
Take a minute to think about how powerful that shift is.
Instead of making someone else rich, you could pad your retirement savings or even bump your retirement date up.
Another quick way to think about this is by using the Rule of 72. Basically, you take 72 and divide by the average return and that is how long it will take your money to double.
72/8% Return = Money doubles every 9 years
The first double is cool, but the second, third and fourth make fortunes.
Action Item: Take the cost of your loans and see what they could do for you if invested using this calculator. Make sure to set the calculator to annually and use 8% to mimic average stock market returns.
Next Up: Looking at Lifestyle Inflation