19.1.12

Be Your Own Investment Manager Part 3: Invest in Your Debt?

by Ed
(image source)
 Part Two in this series focused on Finding Money to invest with, either by "Paying Yourself First" or developing a Spending Plan that leaves you some leftover investment money.  (If you missed that post, you can find it here.)


This week I'm going to get you to look at this money and consider investing in...your debt?



I'm a bit of a tease.  Just when it looked like I was actually going to tell you how to invest, I'm going to buzz-kill and talk about Debt.


There is something inherently un-fun about Debt and Credit.  When I ask students in my class what other words pop into their head when I say the word 'credit', it is almost never anything positive.  (Do a Google Image search on the word 'credit' and you can see that they are not the only ones with negative associations.)


I'm not going to go into my total spiel on Credit.  Suffice to say, I am not against it.  It is really tough to live in the modern financial world without operating with some debt once and awhile.  Most of us would never own homes or drive cars without some debt.  But consider this before you start investing the money you have found: the best use for it might be reducing your current Debt.



Good (OK) debt vs. Bad Debt: 

I grew up with parents who constantly talked about debt and how "owing money is bad" and painted all debt with the same brush.  Don't get me wrong, if a magical Leprechaun granted me a "Debt Free" wish right now, I would take it, but that little green bugger isn't likely coming.


So let's talk about what Debt you should pay off before investing and what debt you can live with.




The Good (OK) Debt:


Mortgages:

My parents used to especially go on about the Mortgage, and for good reason.  Interest Rates were high when my folks had their mortgage.  But, generally speaking, a mortgage isn't terrible debt (provided you can afford the payments in the first place).  What makes it good?


Firstly, a mortgage is a secured debt.  If you don't pay, the bank has collateral (your house).  This means mortgages have lower interest rates, as banks are bearing less risk.


Secondly, mortgages buy houses and real estate.  These assets generally increase in value over time, so they are investments in and of themselves.  Like all borrowing, you should shop around and get the best rate you can, but as long as you can comfortably make your payments, don't sweat your mortgage too much.




Student Loans:

While I don't like it, I still owe a bunch of money on my student loan.  Why haven't I paid it back more aggressively?  The real question is "Why should I?".


There really is no good reason to pay student loan debts off early (unless you have all your other debt paid off and still have money to burn or you funded you education by credit card - yikes).  Student Loans carry a very reasonable interest rate and a percentage of the interest is tax deductible (in Canada).  Why is this the case?


In the crazy 80's and less crazy early 90's, students were declaring bankruptcy in droves to shed massive student loan debt before they started their "real lives".  The Federal government put an end to that, but realizing many ex-students might just wait out the time restriction and still declare bankruptcy, they added incentives to encourage students to pay off their debt on their own.


Take advantage of those incentives and pay off other, more ugly debt before you lose sleep over your student loan.

(photo source)

The Bad Debt:

Credit Card debt:

If you are paying 'minimums' and carrying a balance on your credit card, you've got Compound Interest working against you.  You are paying interest on the interest.  Add to that, Credit Card interest rates are very high.  Typically, you're looking at the 15%+ range ('store' cards like Sears or Canadian Tire can be upwards of 20-26%).


There are no investments that pay you guaranteed returns at those rates, but I can guarantee that your Credit Card company will demand that you pay them.  The faster you pay them (ideally the whole balance before the due date) the less you have to pay those crazy rates.


Paying credit cards off is like paying yourself a 20% return on your debt 
- You will now get to keep all that money you spent on interest before - Nice!


Why are credit card rates so high?  Unlike your mortgage, the credit card company has no collateral to seize if you don't make your payments, so they need to be compensated for this greater risk.  Plus the stuff we buy with Credit Cards almost always depreciates quickly, so even if you offered it as payment, it likely wouldn't cover your whole bill.  Credit Card companies aren't in the business of fencing your old iPod or your half-consumed cup of Starbucks.


Paying your maxed out credit card off is the best 'investment' you can make if you are in this situation.



Back payments owed to Utilities, phone companies, municipal taxes etc.:

See above.  Plus they hurt your credit score so you could end up paying higher interest on some good debt things like a mortgage.  Generally, if the higher the Interest Rate the greater your focus needs to be to pay it off.




Buying Stuff from places that let you pay it off with deferred or 'low monthly payments':

Most 'No Interest' or 'Pay in Interest-Free Installments' financing comes with an up-front charge for 'Paperwork' or something equally nebulous.  This charge often works out to be 15-20% of the cost of whatever you are buying.  

So really when they say 'No-Interest' what they should say is "Pay-All-Your-Interest-Up-Front-With-The-Option-to-Pay-Even-More-Later-if-You-Don't-Pay-the-Total-Off".  (Of course that name is really long, cumbersome to say in advertising and it Test Marketed poorly.)  So No-Interest?  No Payments?  No Thanks.


This advice goes double for those 'Rent to Own' places.  I won't go into the math, but generally you could buy whatever it was several times over if you just saved up and bought it instead of 'treating yourself' before you can really afford it.


In rare occasions, you can find some decent 'No Interest' options (Home Depot often has no-strings-attached financing).  But even these are deadly if you forget to pay when due, as all the deferred interest comes back and it brings friends.



Where do car loans sit?

Well, if it is a car you need to get to a job that generates money = Good Debt.

If it is a car you need because you were bored with your old one and you needed a shiny, sexy, ego boost = Bad Debt.



No matter what debt you take on, shop around to get the lowest interest rate.

Play one bank against another and you will win.  Robin and I are pathetic negotiators, but armed with a simple online e-mail quote from one bank, we got our mortgage rate reduced by our real bank (who we actually wanted to deal with).  They didn't even bat an eye.  (We've since learned some tricks to negotiate better - read about them here.)


So, let's say you've done the "Find some Money" thing.  You've paid all your bad debt and made peace with your good debt.  What next?  Invest it.  No foolin', for real next time we'll talk about some actual investing basics - Risk and Return and how different investment options stack up in each area.


In the meantime, some Risk-based homework (no, Robin, not how to hold Asia with fewer troops - did you know Robin's addicted to playing the Risk app?) - Risk in investing means this: How comfortable are you with the idea of losing all your money in an investment?  Could you sleep at night if that was the case?



Keep reading...



The "Be Your Own Investment Manager" Series:




Part 1: Best Time to Start
Part 2: How Much and How Often to Invest
Part 3: Invest in Your Debt?
Part 4: Risk and Return
Part 5: Mutual Funds
Part 6: Simple Investment Options
Part 7: Saving for Retirement (RRSPs)
Part 8: The Colour and Psychology of Money
Part 9: Saving for Education




3 comments:

  1. I just discovered your blog today. I like all the subjects, but wanted to comment specifically on this one. I read Parts 1-3 for BYO Investment Mngr. THANK YOU SO MUCH!! I appreciate you taking the time to write on this subject. We are currently working on plenty of bad debt (sigh!) but do have some good debt and are investing a bit each pay day. Funny that you talk about dieting as that is how I feel about my current situation. My husband and I made the mistake of looking around and saying 'Hey how come they get to eat junk food all the time? We want junk food too!' So we preceded to go crazy only to wake up from a junk food coma and discover that we were morbidly obese! That 'junk food' was stuff like new vehicles and vacations and our obesity was several (too embarrassed to say how much)thousands of dollars owed on credit cards and our LOC. I agree with you that students should be req'd to have money/investment information before they graduate. The Taming of Shrew is certainly good, but it doesn't help me at all when I open my bills each month or when I stare blankly at my rsp investment info from the bank hoping but not really knowing if I will be on the positive side down the road. Looking forward to reading more. Thanks again!!

    ReplyDelete
    Replies
    1. Thank you for the positive feedback. I'm sorry to hear about your debt situation, but you should be commended for actually recognizing it and doing something. Many people who have been taking advantage of the all-you-can-eat credit buffet are not being as diligent.
      I would like to add your 'junk food' parable to my budgeting lesson - it is a great analogy. -Ed

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  2. I hope the junk food parable works for you in your lesson. Although disappointed by our debt I figure someone has to serve as a bad example for others :) I imagine it can be hard to always reply to comments so thank you for your reply! - Tamaira

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