Debt, we all love using it, but we all hate having it. I believe debt in and of itself is neither good nor bad. It’s neutral. However, the use of debt can provide varying degrees of good or bad outcomes for people. As a financial advisor, I coach my clients to view debt as a tool to accomplish a goal. If not handled correctly, it can be a very dangerous tool that has the ability to wreak havoc on their financial life. Now, before we dive in on how to use this tool effectively, here is a quick debt guideline to keep in your back pocket.
Debt Rule of Thumb
A good rule of thumb is to only use debt when purchasing items that are likely to increase in value over time, like a home in a desirable geographic area or a business that you have principal control over. By financing these types of items, you can use the power of leverage to build a bigger net worth. So, what should we not use debt to pay for? Items that are likely to decrease in value. What comes to mind here for most people are cars or boats, but really it could be anything that is being sold with a promotional financing option like a vacuum cleaner, mattress, kitchen hardware, etc… Not only will these depreciate over time, but by using debt to finance them you are vastly overpaying in the first place. Here’s what it looks like.
Truth in Lending? Not So Much
If mortgage advertisements were honest, they would say something like, “The cash price of this home is $300,000 but can I interest you in paying $600,00 instead?” Over the life of a standard 30-Year Fixed mortgage, the amount of interest paid will almost double the price of the home over the life of the loan. And guess what, it’s the same concept for using debt to pay for a vehicle, a boat, or anything else.
“You are electing to overpay in price for the benefit of having the item before you can afford it.”
The longer the loan, the more dramatic the price increase.
Now I’m not bashing this system in any way, in fact, I’ve used two 30-Year fixed mortgages to purchase homes I otherwise would not have had the capital to afford. What I’m saying is just be aware of what you are signing up for, and to understand the impact of this decision over your lifetime. Also, what kind of financial planning blog would this be if I didn’t have a couple of solutions and tips to help with this home lending dynamic?
Mortgage Payment Tips
Here is what a modern 30-year fixed rate mortgage will likely look like if you have good-to-excellent credit (for those with poor credit the interest rate and interest paid will be higher and more over the life of the loan). Let’s say you borrow $300,000 to purchase a home, and because of your good credit and current rates, you get an interest rate of 4%. If you make the minimum payment of $1,432 per month, your loan will be paid off in 2049 and you will have paid an astounding $215,6081in interest.
Only Making the Minimum Payment
This interest amount is not quite double the purchase price, but still a significant increase from the $300,000 cash price. If you have less than excellent credit or rates increase to 6%, the interest paid over the life of the loan increases to a depressing amount of $347,5152. So, what can we do about this?
How to Keep Mortgage Flexibility and Save Money
When you finally buy that dream house and lock in your 30-year fixed loan, you have also locked in your monthly payment. The 30-year fixed is used most often because that locked-in payment is lower than if a 15-year is used. This makes sense for most peoples’ budgets, but the downside is the massive amount of interest you will pay over the life of the loan.
Now you might be thinking that it’s unlikely you will stay in the same house for 30 years, so what should you do? You’re right, you probably won’t stay for 30 years and lenders are well aware of this. That’s why they stack the interest portion of the payment at the front end of the loan. The majority of your minimum payment will NOT pay down the principal, it will go towards interest. So, the best way to combat this is to throw any extra money you have at the principal balance in addition to your minimum payment. The images below will illustrate the power of this strategy.
If you pay an extra $100 per month towards the balance of your loan, you start eating away at the ability of the bank to charge interest on a very large principal balance.
Paying an Extra $100 per Month
This small amount saves $28,682 and the loan is paid off almost 4 years sooner.
What about $500 extra per month?
Paying an Extra $500 per Month
Now we’re talking. You have savings of $92,375 and 11.66 years sooner. This is fun, let’s keep going.
Paying an Extra $1,000 per Month
If you can swing this, you effectively cut your loan payment time in half, and save over $128,000 over the life of the loan. And you maintain the flexibility of having the locked in lower payment if you find you are unable to pay any extra for any given month. So, remember to be wise about your use of debt and apply any extra amount you can towards the principal balance of a mortgage or other liability you have3.
Please feel free to reach out to me if you have any questions about this, or if you would like free access to use our financial planning software that includes debt reduction tools. Or check out some of my other posts for other tips and strategies.
Stevie Heitzmann is the CEO of Altruistic Investing LLC as well as a financial advisor at Bauer Wealth Management LLC, both investment advisory firms based in Colorado Springs, CO. www.altruisticinvesting.com Altruistic Investing LLC is a Registered Investment Advisor (Firm CRD# 289016 / SEC#801-110892) with the Securities and Exchange Commission. Bauer Wealth Management LLC is registered with the Colorado Division of Securities (CRD#: 152977/SEC#: 801-71090)
This article does not represent an investment recommendation or endorsement of any kind. Please consult with your advisor regarding your specific situation. Investing in securities does involve risk of loss that clients should be prepared to bear. The risks can range from failing to keep pace with inflation to losing some or all of the money you invest.
References
Hayes, A. (2019, July 29). Understanding Leverage. Retrieved August 7, 2019, from https://www.investopedia.com/terms/l/leverage.asp
Right Capital Financial Planning Software was used to generate the debt illustrations. If you would like free access to get started on a financial plan using this software, click here.
- Assuming a fixed annual interest rate of 4% over 30-year term with monthly payments and principal balance of $300,000
- Assuming a fixed annual interest rate of 6% over 30-year term with monthly payments and principal balance of $300,000.
- This mortgage strategy should be used in conjunction with paying off other liabilities. Different strategies can be deployed depending on each individuals unique situation.