Being debt free isn’t necessarily the best thing you can do. Learn how to use debt as a financial tool and be better off.
A lot of the personal finance blogs on the net revolve around paying off debt and living a debt free life. I’ve seen debt, especially from payday loans and high interest credit cards, destroy peoples lives and understand the need to get out of debt.
But is there a good use for debt as well? I’ve also seen a lot of sites warn people to pay off all their debt as quickly as possible or risk financial calamity. I call these the Debt Deniers!
You see, while misuse of debt and high interest charges can ruin your financial future, the responsible use of debt can actually help you achieve your financial goals and live happier than ever. This has never been more true with interest rates hovering at record lows. It all comes down to good debt vs. bad debt, something we looked at in more detail with a prior post Being Debt Free or Just Free of Bad Debt.
How do you manage your debt? How does the interest you pay stack up against the return and quality of life you achieved from the debt? Check out the infographic below for investments that return a profit even after paying interest on a loan. Notes and details are below.
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Debt Free or Using Debt for Investing?
The infographic compares a 30-year loan of $50,000 at 3.75% against the performance of several investments over the last three decades. At that rate, your mortgage payment would be $231 each month and has been deducted from the proceeds on the investments. The profit shown for each investment is the additional money you earn over the 30 years.
Working your way down the list, it’s easy to see why debt free isn’t always your best financial choice. There is a reason why major corporations and governments use debt as a financial tool, leveraging your assets to make a higher return just makes sense.
At the safest end of the investment spectrum are bonds of extremely safe companies. Giants like McDonald’s and Coca-Cola are not going to pay you much interest on their debt but you are almost guaranteed to get everything promised. With a 30-year profit of just $940 after deducting your monthly mortgage payment, it probably isn’t worth it if you are only going to invest in bonds at a 3.8% return.
Using debt as a financial tool versus being debt free is an important, and sometimes difficult, decision for a lot of people. If you have a tough time budgeting, saving and controlling your spending then you may want to avoid debt all-together. It can be a slippery slope but using debt and controlling it can help you achieve your financial dreams.
Beyond investment-grade bonds, you’ll find higher returns in riskier bonds and peer lending. The return to current loans on Prosper is 6.9%, similar to the return you will get from high-yield bonds. The problem with peer loans and all bonds is that the money you receive on a monthly or semi-annual basis is taxed as income. Even with that disadvantage, these investments are still safer than many others and you can book a return of more than$100,000 over the life of your loan.
Check out the Corporate Bonds group of stock funds on Motif Investing for a dividend yield of 4.1% and a return of 6.4% over the last year. The safety of corporate bonds with higher yields.
Should You Use a Loan to Invest in Stocks or Real Estate?
Even after the two stock market crashes this millennium, stocks in the S&P 500 have returned 7.2% over the last 30 years. These are the largest companies in America and relatively stable over the long-term, so not as risky as smaller companies. The drawback is that there is no contractual return as there is with bonds and you are at risk to the investing decisions that plague many investors. Hold your stocks for the long-haul, avoiding the panic-selling when times get tough, and you could see a profit of nearly $128,000 over the 30 years.
Despite the bubble of recent memory, real estate has been a great investment over the past three decades. The NAREIT Equity Real Estate index, a grouping of commercial real estate investments, has returned 11% annually over the last 30 years. While buying property directly may be out of reach for many investors, real estate investment trusts (REITs) offer the opportunity to spread your investment across many properties and many places with one purchase. Investing in the index would have returned $586,484 over the period.
Is it Really a Student Loan Debt Crisis?
Topping every other investment is the one you make in yourself through education. With the ballooning of student debt, I’ve seen a lot of people question the value of a degree. I’ll agree that the for-profit and online schools likely do not offer a good return on their high costs and low graduation rates but traditional schools still offer a lifetime of opportunity. Research firm Payscale looked at costs and income for graduates at 900 universities across America. Factoring in the cost of a degree and earnings, they estimated the financial return to a college education.
There were differences between schools and degrees. Degrees in engineering and other hard sciences returned more while arts and humanities degrees returned less. The study found a median annual return over 20 years of 11.6% that I would say is actually underestimating the true return because it doesn’t factor in the improvement to quality of life. With a university degree you gain more control of your employment opportunities and don’t have to take any job that comes along. Using just the 11.6% annual return nets you more than $719,000 over the 30 years and a lifetime of other benefits.
Debt Free versus Debt as a Financial Tool?
We could fill a book with disclaimers on investing and the use of debt to reach your financial goals but it really can be as simple as earning a higher return on your investments than the interest you pay on debt.
A few things to consider:
- While the examples above are taken as a singular choice, your investment portfolio should be a mix of different assets. Stocks and real estate have performed well over the last three decades but have plunged during shorter periods. Mixing bonds, stocks and real estate together in a portfolio lowers the risk considerably so you don’t have to watch your investments shrink during the next market collapse. A portfolio equally-weighted across the first four investments above would have returned 7.23% annually and a profit of $132,000 over the thirty years. Check out these eight stock market basics and how to start investing on our sister blog.
- As we say in the investment biz, past performance is no indication of future returns. Thirty years includes many business cycles and the returns from each investment should be true measures of what you’ll get in the future. Still, there is no way of really knowing how much you’ll earn in the future.
- I haven’t included taxes to the calculations above since it varies so much depending on your own situation. For those in the higher tax brackets, the return from bonds and peer lending may not be as attractive because the cash received is taxed at a higher rate. Consider tax-free municipal bonds or placing your peer loans in a tax-advantaged retirement account.
The biggest consideration is just that you need to use debt responsibly. Like any tool, using debt irresponsibly can smash things up pretty good. If you are taking out high-interest loans or using your debt to pay for things you don’t need or that will not provide a return then you are better off not using debt at all.
Use debt wisely though and you will find a whole new world of financial leverage and will be able to set your financial goals higher. What are your favorite uses of debt or are you debt free? Do you have a debt story that you want to share as a PeerStory?