Tag Archives: good debt

Bad debt, good debt & cost of borrowing money

Growing up, I never thought of borrowing money as a tool, rather it was a sign of not having enough money to pay for whatever you were trying to buy. It wasn’t until I started working that I learned more about it. Internet has a lot of information about types of debts, so I’ll skip that part. You can read about it on investopedia, bankrate, or cnbc to name a few websites.

What is considered bad debt may not be so depending on how you use it – it can be explained by considering the cost of borrowing money. Interest is what we pay to use other people’s money (OPM); there are several things to consider when borrowing, some of which are following:

  • Total amount borrowed
  • Fees associated with loan process
  • Interest rate
  • Length of borrowing
  • Early repayment terms

Looking at the bigger picture, this can be used to your advantage and possibly also help acquire good debt.

Bad Debt #1: Car Loan

Last year when I was buying a car, I had thought about paying cash since car loan is typically considered a bad debt – it seemed like a good idea until I ran the numbers:

  • I was getting a car loan for upto $25K at 1.99% without any other processing fee or extra charge
  • I was also considering buying a house in near future

I could pay cash for the car and figure out the house down payment later or, which I eventually ended up doing, take a car loan an put more cash towards the house. Our home loan had interest rate of 4% and we didn’t have to pay PMI because of the extra down payment I could afford. Considering that the interest for the car loan is half of that for the house, it turned out to be a good deal.

debt

Bad Debt #2: Credit Card

I always pay credit card bills on time and never carry any balance. In this one instance, I had to pay the bill on Thu and I was going to get paid, a day later, on Fri. I paid the minimum balance on Thu and waited to get paid to clear rest of the balance; total interest paid <$1. The high interest rate for credit card is the yearly rate and unless you plan to not pay for an entire year, the interest doesn’t accumulate much. Compare that with payday loan or bank overdraft fee, both of which cost more than $30!

Bad Debt #3: Store Credit card:

I am not a fan of store credit card in general, primarily because those can’t be used anywhere else. After buying the house, we still had to buy appliances and furniture. I did research on what I wanted to buy and compared prices at 3-4 physical stores besides checking online. Finally went to the one which had the lowest price for what we wanted (considered brand name, type of appliance, size etc.), they were also willing to price match.

I was going to buy from there for the lowest price alone, but they offered more discount if we used store credit card. The card also came with 0% interest for 18 months, which was an added advantage. That’s the only time I’ve used store card and didn’t think it was a bad debt because of the savings and not having to pay any interest.

When making a decision about using cash vs OPM, consider above factors and remember to do your own calculation not what the seller shows you.

P.S. My friend and I had this joke about me not willing to pay $500 to get my mustang’s broken window repaired. His exact words, “You didn’t want to pay $500 for the window, so you bought a new car for $15,000?!” I had my reasons. 

 

Can’t decide between 15 vs 30 year mortgage? Lets’s look at what math says

There are several decisions to be made while buying a house and probably one of the most debatable one is the mortgage term [15 year vs 30 years]. When I asked around, there were folks in both the camps – everyone had a valid point. Quick search shows millions of results about endless discussion that are out there.

What if there was a way to get the flexibility of 30 year mortgage and payment terms (almost) of 15 year? With following assumptions, let’s do some maths to find out:

  • Loan amount: 300K
  • 30 year interest rate: 4%
  • 15 year interest rate: 3%
30 yr rate 4%
Monthly payment $1,432
Total Cost $515,609
15 yr rate 3%
Monthly payment $2,072
Total Cost $372,914

Above table shows the monthly payment and total cost of both the options (use any mortgage calculator online to get the numbers for your loan value). Since most of the loans do not have prepayment penalty meaning you can always pay more than the required monthly payment and the extra goes towards the principal.home

Accelerated payment calculation:

If you pay the difference (2072 – 1432 = 640) towards the principal, the total accelerated payment would be $410,289 which gives you savings of $105,318 and shortens the time of repayment by 13 years 6 months. But the original saving with the term and interest difference was $142,695   ($515,609 – $372,914) so the accelerated payment method costs you $37,375 more, which I call the cost of flexibility and piece of mind knowing that if something happens within those years and you can’t afford the higher payment, you’re not stuck with it!

Net Present Value (NPV) of the total payment: 

Since the mortgage payment amount is fixed, above calculation wouldn’t be complete without considering the effect of inflation. Let’s consider the NPV of the total payments considering standard 3% inflation:

  • 30 year payment NPV: $340,504
  • 15 year payment NPV: $300,787

Since the payments are in future dollars, the buying power (value) of the dollar will be less compared to the value of dollar today. To put this in perspective, consider what $100 gets today vs what it bought 20 years ago.

Note: Above calculations doesn’t consider either other payments such as tax, insurance etc. or the tax tax advantages we get from the interest payment.

investOpportunity Cost

Opportunity cost should also be considered to look at the bigger picture. Let’s say you take 30 year mortgage and invest the monthly payment difference in stocks, which historically has given 7% return.

total value of investing $640 every month for 15 years considering 7% annual return is: approx 200,000; which is more than the difference in savings you get from 15 year term.

Paying every 2 weeks:

Lot of online discussions revolve about paying the loan every 2 weeks instead of monthly, with the logic that the interest is based off of the total outstanding principal and if you pay every 2 weeks (half the amount), it lowers the principal and in turn lowers the interest amount in the long run. Check your financing documents to see whether your lender accepts “Partial Payments”; if they don’t, then the amount you pay every 2 weeks will sit in their bank account without being applied towards the loan – which is similar to you giving the bank free loan for 2 weeks.

To sum it up:

While it’s prudent to get 30 year mortgage and invest the difference somewhere else (mortgage is considered good debt), however, there is always an option to pay more and thus early payoff on 30 year terms, which gives flexibility to folks who would like to pay if off sooner.