I’ve always been a bit neurotic about money management. Conservative principles about money were drilled into me from a young age; I worry about it more than most people. But, this anxiety has served me well. Following my undergraduate graduation, once I started making decent money as an engineer, I lived reasonably frugally. Consequently, I had a lot of savings and credit available when I made the decision to leave my job and forego income for 16+ months. That long period of time enabled me to execute a major career transition from engineering to analytics. This would have been impossible without substantial savings and the ability to live cheaply.
During that 16-month period, in an abundance of caution, I avoided spending my saved cash whenever possible. Instead, I levered myself like crazy to maximize the total time I could last without income. As a result, the assets I still have available could probably last me another 18 months. But, I have also accrued pretty substantial debt (albeit, at relatively low interest rates).
In late August I successfully completed my career transition into analytics by accepting a full time data analyst position. As I rejoin the work force, I find myself with a (relatively?) large amount of debt, but also enough saved, liquid assets to pay almost all of it. How much of my savings to spend on debt elimination is not clear to me.
This post is my attempt to tease out a reasonable path forward. I intend to straddle the lines between ultra-conservative Dave Ramsey strategies and an approach that would maximize investment income but at the cost of assuming high levels of risk.
I discuss these different approaches to personal finance in the next section.
Approaches to Debt
The Full Ramsey
- Save $1,000 to start an emergency fund
- Pay off all debt using the debt snowball method
- Save 3 to 6 months of expenses for emergencies
- Invest 15% of your household income into Roth IRAs and pre-tax retirement funds
- Save for your children’s college fund
- Pay off your home early
- Build wealth and give
Much of this is sound, traditional financial advice, but in step 2 Ramsey’s approach becomes controversial. The “debt snowball method” entails ceasing all nonessential spending and applying all the liberated cash flow toward paying off all non-mortgage debt. It also involves liquidating all investments and reducing total savings to the $1000 saved in step 1. That is the part that I really struggle with. I hate the idea of foregoing an emergency fund. The order of debt repayment Ramsey recommends is from smallest to largest total money, irrespective of interest rate.
No shortage of angry YouTube comments have been written about how Ramsey’s approach is mathematically suboptimal and draconian. This is true on at least one count. Advocates of the approach say that the wisdom of this is that fixing out-of-control personal finance situations is primarily an exercise in behavior modification, and only peripherally related to financial mathematics. I’m better at math than human psychology, but I’ll go with Ramsey on this one. It seems wise.
Max Investment Income
This approach is the opposite of what Dave Ramsey recommends. Whereas the goal of Ramsey’s approach is to minimize debt and risk, the goal of this modern and popular approach is to maximize investment income.
Debt is not considered a bad thing, on this view. Strict adherents of this approach would recommend borrowing money at a low rate and then investing it at a higher rate, for example. If you’re savvy about investing and managing credit, it is possible to abuse balance transfers and introductory rates to obtain several thousand dollars at a 0% interest rate, and then invest that “free” money and earn 10+% interest. In the past I’ve done this successfully. The consumer credit system is easily abused.
But, this investment income is not as “free” as it may feel. The investor assumes substantial risk by employing leverage, and frankly I’m not sure the emotional toll is worth a couple extra grand per year. Invest the same amount of emotional energy in improving your performance at work, and you will likely earn a larger ROI.
I am prone to overanalyzing money management; my head can spin on the subject for hours at a time. For this reason, the extreme simplicity of Ramsey’s approach is very alluring. I also like math and spreadsheets and I understand the time value of money. So, I am sympathetic to criticisms of Ramsey’s approach. And I also like new cars and Apple products. A lot. Hence my internal conflict.
Much of my personal finance life has been spent maximizing investment income, as described above, and employing debt were the mathematics indicated it was appropriate. I have undoubtedly made money this way over the years. Going forward, I want to chart a more reasonable, lower risk path forward, so thoughts of money will be less all-consuming.
Savvy Middle Ground
A middle ground between the two extremes described above would involve using financing intelligently while also simultaneously eliminating my more expensive debt. It would also focus on the priorities outlined in Ramsey’s baby steps, in roughly that order. It may or may not involve becoming entirely debt-free. The savvy middle ground involves considering debt on a spectrum of desirability, depending on the interest rate.
Next I’ll compile a few data points that will help define what ranges of interest rates on debt are more and less desirable.
There aren’t many risk-free investments. Some might tell you there are zero. My thought is that if investments widely regarded as “risk-free” are defaulting, I will have more pressing concerns than single-digit differences in return rates. I will probably wish I had invested my money in guns, gold, and drinking water.
With that in mind, one bet that I feel comfortable making is that inflation will continue to be positive and roughly similar to what it has been the past several years. A logical outworking of this assumption is that financing at a rate less than inflation really is less expensive than paying cash. Cash depreciates at the current inflation rate.
This site lists current inflation and inflation for the the past couple decades. Average annual inflation for the ten year period ending in 2017 is 1.8% and current inflation is estimated at 2.9%.
Investments exist on a continuum from low-risk, low-return to high-risk, high-return. The opportunity cost of purchasing something outright rather than financing it is the lost investment income from spending that cash, which could otherwise be invested.
A few investments to consider:
- One very safe investment to consider, with rate approximately equal to inflation, is Vanguard’s Short-Term Bond Index Fund (VBIRX). It currently yields 2.8%.
- More ambitious (and no longer low-risk, but a favorite of mine) is Vanguard’s High-Yield Corporate Fund (VWEHX). It currently yields 5.6%.
- Average annual returns of a total stock market fund (for example, VTSAX): 7.0% since inception.
- Annualized effective compound rate of return for my complete Fundrise portfolio: 8.3% since February, 2016.
- Mid-performing Fundrise funds (East Coast, Heartland, and West Coast eREITs): annnualized returns of 8.4% since November, 2016.
- High-performing Fundrise funds (Income and Growth eREITs, and Fundrise iPO): annualized returns of 11.4% since February, 2016.
I consider investment #1 very low risk. Intuition tells me that the Fundrise funds (#5 & #6) are actually the next most stable returners. At current valuations I wouldn’t feel comfortable investing substantially in #3 and #4, but the rates of return are useful metrics to keep in mind.
The actual rate of return for that investment is the nominal investment return less the investor’s marginal tax rate. I fall into the 24% and the 9.3% tax brackets for federal and state taxes, respectively. Thus any investment return rates must be reduced by 33.3% (!) to make an apples-to-apples comparison between debt costs and actual investment profits.
In conclusion, I distill all this to the following rough categories of debt.
Great debt is anything less than roughly 2.5%, which is close to current inflation. Betting on continued low-single-digit inflation is probably the safest “investment” anyone can make; you “invest” in inflation by financing at less than 2.5%.
Good debt is above 2.5% but less than 4.0%. That upper limit is driven by the probable after-tax returns of Vanguard’s VTSAX and VWEHX, which are accessible and liquid, if volatile, funds.
Okay debt is less than the average after-tax investment returns you currently make. If I were in the position to invest, my next invested dollar would probably go towards mid-performing Fundrise funds, the historical after-tax returns for which have been roughly 5.5%. These funds are less liquid and less well-understood than the Vanguard VTSAX and VWEHX funds covered above, but they have been consistent returners since their inception.
Any debt that falls outside those ranges should be paid off. Doing so is mathematically identical to making an investment with guaranteed, after-tax rate of return equal to the interest rate.