Monday, June 18, 2007

When Good Debt Goes Bad...

So right now, my wife and I are trying to pay off some "bad" debt, before we start rapidly accumulating post-tax investment capital. What's interesting is that the tax deductibility of the debt makes a HUGE difference in whether debt is good or bad....

Here's a run-down of our debt:
1. Mortgage debt, 30 year fixed rate at 5.75%, this works out to an after-tax return of around 4%. Bloggers and "financial gurus" who tell you to pay down your mortgage at these interest rates are fools. We could earn a better rate of return on a treasury bond (almost), plus the mortgage allows us to enjoy a great return on the leveraged appreciation of the house.
2. Ultra-low interest federal student loans- Always be suspicious if someone tells you they need to borrow money to pay down federal student loans, as these are usually ultra-low interest rates, but are one of the few loans which survive bankruptcy.
3. Second Mortgage at 8%- While this is pretty high, it is tax deductible, so it is lower than the long-run return on the market, though many would jump at the chance to earn a guaranteed 8%. I will probably split my money between the market and paying this loan down.
4. Private Student Loans at 7.035%. The thing to note here is that because of taxes these student loans are actually higher than the second mortgage. The non-deductible 7.035% is equivalent to a market return of 11.5%. A guaranteed no-brainer.

4 comments:

Anonymous said...

i've always heard you should pay down debt before you save money. although, i am assuming from what you're saying, is that you should pay down debt at the higher interest rate but then let the lower interest rate debt alone and start saving at the same time as paying on the low interest debt?

Alex said...

I take the philosophy that your money should go to source of the maximum risk-adjusted return. The 7% student loans represent a guaranteed return equivalent to a 11.5% return, so this represents the maximum potential return.

The 5.75% mortgage represents a far lesser return than the average market return.

Angie Hartford said...

How does saving for retirement, and the return on investment, figure in here? If you can get a higher than 7.035% from investments and tax advantages, wouldn't it make more sense to max out retirement contributions, first?

Alex said...

My wife and I pretty much max out our tax advantaged contributions. So the answer is yes.

Though we may decide to start making non-deductible contributions to an IRA in the hopes of converting it to a Roth IRA in a few years when the tax laws change. But that is the subject for another post.