There are so
many misconceptions about finances. A simple internet search will show articles
about how to save money each week, how to use a side gig to make more money,
etc. No wonder people think the way to getting “rich” is not splurging on the
coffee on you commute to work and brown bagging your lunch each day.
But there’s a
difference between money and wealth.
Truly
“wealthy” people know different. Among other things - either they, or their
advisers, understand that money can work for them. This could be in the form on
a business, investment real estate, or even mutual funds.
What does
this mean for the average person?
Well, there’s
a popular author and radio host who gives advice that many people find helpful.
As you’ll see in a moment, it’s focused on money - and not building wealth.
This person advises a series of steps, and people are supposed to do them in
order. While those steps aren’t “wrong”, they do overlook an important concept
of building wealth.
In steps 4
and 5, this “expert” suggests that the rate of return on savings is 12%, which
is the highest legal limit an adviser can assume. IF, and that’s a big IF, you
assume this is correct, then you should ignore this person’s first 3 steps if
the interest rates on your debt are less than 12%. After all, you would earn
more on your money than you would owe in interest, so why would you want to pay
off the debt early???
Let’s look at
a hypothetical scenario:
Joe Smith has
$35k in student loans. They carry an interest rate of 5%, and the repayment
period is 10 years. You’ll note that these terms are very similar to the
current Federal Direct Loan program for undergraduates.
This means
that each month Joe has a payment of $371. Under the regular payment schedule,
he’ll pay a total of $9500 in interest over those 10 years.
Taking the
advice, he finds ways to cut his expenses and is able to make an extra $100
payment per month (step 2 of the “advice”). By doing so, he’ll be debt free in
93 months, or just under 8 years. He’ll pay just over $9000 in interest.
You can see
the difference in the chart below.
And there is
a LOT of psychological value in being debt
free. The feeling is priceless.
Let’s take a
look at an alternative scenario. Let’s suppose that instead of sending the
extra $100/month to pay down the loan, Joe invested it at the 12% per year that
this author / radio host assumes.
Yes, he’s in
debt for the entire 10 years, but he also has over $23,000 in the side fund at
the end of that period. He accomplishes steps 1, 3, and starts 4 all at the
same time.
For
comparison, if he follows the steps in order, waiting until the debt is paid
off to start saving in step 4. At that time, Joe would be able to save
$471/month - the original loan payment and the extra. But he wouldn’t start
until month 94. At the end of the original 10 year period, Joe would have
almost $15k.
You can see the difference in this chart.
Do you see
what happened? If he follows the steps in order, Joe just threw away over $8000 unintentionally!
Yes, he saved
over $500 in interest and about 2 years worth of time by paying extra on his
loan payments, but if he had invested the money instead, he would have over
$8500 extra in his savings.
Which would
you rather have - $500 in interest savings or an extra $8500 in the bank? Either
way, the loan is paid off.
Let’s
continue the example. Let’s suppose that after the 10 years, Joe invests the
$471/month for the next 20 years. What happens?
Continuing
the account from $23k, after 20 years, Joe will have $742k!
Continuing
the account from $14k, after 20 years, Joe will have $640k.
Why this
author’s advice doesn’t work:
Every
situation is different, and it shows that while paying extra on debt does save
time and interest, it may not be worth it. If you truly can earn a large
return, steps 1 and 3 cost you money in terms of lost return.
Why this
author’s advice (generally) does work:
Earning 12%
isn’t realistic. With more realistic returns, paying off debt first may
be better than saving in a side fund. The higher the interest rates – or the
lower the assumed return, paying off debt first becomes more advantageous.
Ultimately,
what’s the answer here?
Every
situation is different. I can’t stress that enough.
People focus
so much on money and not on wealth. This example clearly shows how Joe could
unintentionally throw away money. Having debt is not necessarily a bad thing.
What’s your
view on this? Are you trying to be good with money, but unknowingly preventing
wealth?
