Ep 13 - The Truth About Debt: How to Use It, Beat It, and Stop Feeling Bad About It

Hello, friends.

This is Tyler Gardner welcoming you to another episode of your Money Guide on the Side, where it is my job to simplify what seems complex, add nuance to what seems simple, and learn from and alongside some of the brightest minds in money, finance, and investing.

So let's get started and get you one step closer to where you need to be.

In this episode, we are going to tackle the universally applicable topic of debt.

Rich, poor, old, young, we will all face it.

Or we have already faced moments in which we are either in debt or are thinking about going into debt, or struggling daily trying to climb out of debt and wondering how the heck anybody manages to do so while still being able to put food on the table.

So let me start here as a lifelong reminder.

If you are experiencing debt or have experienced it in the past, you are not a bum and you're not somehow less than someone sitting next to you who has not experienced debt or who has less debt.

More frequently than not, those of us who experience debt early in our lives experience it because of the good old birth lottery.

You know, that thing over which we had no control, no choice, that random chaos that created me at birth to parents who were unchosen by me, to a place that was unknown by me.

and to a money situation and environment that certainly had nothing to do with me or my vain attempts to sell lemonade at 10 years old to the neighbors.

Early debt, particularly, is often a product of our environment, just as early privilege is often a part of our environment.

But that does not give us an excuse to not learn more about debt, to think critically about debt, and to do everything we can to understand our own personal and optimal relationships with debt.

Because to spoil one punchline early, all debt is not created equal, and all those in debt are not experiencing the same response to debt.

I know people who have zero assets and are wildly in debt.

And I know multi-millionaires who take on immense amounts of debt every year, depending on their specific venture at the time and whether or not it's a good opportunity.

And yes, I did just call debt an opportunity.

As we will see quickly in this episode, debt is also more than just numbers on a spreadsheet.

It's one of the single most emotionally challenging topics in personal finance.

Although we'd love to believe we're all automatons who crunch numbers in life rationally and can respond easily to different interest rates and monthly payments, that's simply not who or what we are, nor is it how we operate, particularly as it pertains to our money.

What interests me is that even the word debt makes everyone feel slightly differently.

Some people think about opportunity, as I said.

Some think that it is the grand inhibitor of opportunity.

And some people feel that it is really something worth being ashamed of.

Regardless, it must always be something of which we are highly aware, and we would all be well served to know how we respond to debt, just as we would be well served to know how we respond when we get angry at the world or sad with someone.

Some people carry debt like it's just another financial tool, something to be managed and optimized.

Others feel crushed under its weight.

constantly looking for an escape.

Still others, unfortunately, have never learned much about it and feel almost as if they're victim to this unjust script that is designed to keep them in debt.

Then there are those who obsess over the interest rates, strategizing over every fraction of a percentage point to see where they can get the best edge in business or investing.

But at the end of the day, paying down debt is about more than just math.

It's about what gives you the best shot at building long-term wealth while also providing you with a distinct possibility of being able to sleep soundly each and every night.

And I don't know about you, but I do like my sleep.

So today, we're going to break down when and how someone might choose to pay down debt, but we're going to do it a little differently than some of the personal finance advice you've already heard.

We'll go beyond the oversimplified, oh, just pay off all your debt as soon as possible type of mindset, and instead take a strategic approach that balances logic, opportunity, and psychology.

Because to me, personal finance is not only personal, but it is also an art form that necessitates our balancing all of those elements in order to give us a genuine foundation that is both sustainable and realistic.

So first, we'll talk about the concept of a risk-free return versus the opportunity cost of keeping debt and investing that money instead.

Then we'll establish a clear debt emergency scale, a ranking system that helps you figure out what should be paid off first and what might be able to wait.

Finally, we will explore the psychology of debt and why sometimes the mathematically optimal move isn't the best choice for you, your family, or your financial well-being.

So, the first step in making an informed decision about whether you should or should not pay down your debt is understanding the concept of opportunity cost.

Every single dollar you put toward paying off debt is a dollar that's not being invested elsewhere.

On the surface, this may seem incredibly obvious.

But it is perhaps the single most important factor that drives my own financial and life decisions on a daily basis.

The study of economics, and I would extend that to the study of personal finance, is largely the study of scarce resources.

We have X amount of resources, that amount being, of course, finite, and we're looking to do Y amount of things with Z amount of time.

Well, unfortunately, we can't do it all.

So if I want to go out with my friends tonight, which luckily I rarely do because I'm over 40 and prefer being in bed by 8 p.m.

after watching a little bit of Love is Blind, don't knock it till you try it.

Well, then I can't stay in and watch Love is Blind.

That's the opportunity cost or the true cost of going out.

We have to always be thinking that way.

What are we forfeiting by doing something?

As it pertains to our money, if I pay down $1 of debt, I can no longer do anything else with that dollar.

I cannot spend it at the dollar store.

I cannot save it in a piggy bank.

And I certainly can't invest it elsewhere as it's been allocated permanently.

That's why it's crucial to begin by comparing your current debts interest rate to what you could be earning on that money if you did something else with it.

And let me pause here to say that when people say, should I pay down debt or invest the money, what most traditional financial advice does not tackle is how drastically different your options are as it pertains to investing that money and as it pertains to opportunity costs.

There are countless ways that you can invest the money, and each of those would probably provide you with a different answer of whether it's a good idea for you or not.

Let's start by looking at what I might consider to be the safest way to think about the trade-off.

If you pay down a 5% debt, well, that's the equivalent of a guaranteed tax-free 5% return, right?

You no longer have to pay that 5% on the money, and you're guaranteed that return.

So I always start my debt considerations by asking myself, well, is there anywhere else where I could get a guaranteed return?

And lucky for us, at least for now, we have what's called a risk-free asset class.

And that's usually the 10-year U.S.

Treasury bond, or some people use the 90-day T-bill for slightly more liquidity.

Either one is backed by the full faith and credit of the United States government, and yes, insert your clever one-liner here about what that currently means to you, but either one reflects a risk-free return if the bonds or bills are held to maturity.

The 10-year U.S.

Treasury bond serves as a good baseline for my overall decision.

Historically, this rate has hovered between 4 and 5%, meaning that if your debt carries an interest rate below that, then then paying off that debt aggressively might not be the best move because you can get a guaranteed higher return elsewhere.

Now, again, something that most finance folks don't address well enough is that paying down debt is a real return, meaning if I pay down 5%, I get a 5% return.

But if the U.S.

tenure is at 5%,

I still would have to pay taxes on that 5%.

So it's more like 4%.

So when we're thinking about these things, always, always, always used post-tax numbers.

numbers.

That's the only fair comparison.

Not to mention, paying down debt can often be as easy as clicking a button on a bank account or online billing statement, whereas investing in U.S.

bonds, although not particularly difficult for those who do invest, it can be a little bit of a headache, particularly for those who are new to investing.

So even though I use the 10-year as a gauge, it's just that, a gauge.

I do not pretend that there is an objective yes or no in this case or really in any case in personal finance.

Some people honestly would be better served psychologically if they just paid down that 3% mortgage and called it a day even if there was a higher return elsewhere because it was easy and guaranteed and quick.

In many cases, I actually reflect this psychological underpinning because my father spends hours on the phone sometimes with billing agents trying to get back like five bucks.

And every time I ask him at the end, I said, well, was it worth your hour or two hours getting back that five bucks?

And undoubtedly, of course, he says, absolutely.

I get it.

We all have our underpinnings, but that's not not me.

But again, personal finance is personal.

So that's my first gauge, the 10-year.

But let's start to add some nuance to this.

If I were in my 20s or 30s and perhaps had a longer time horizon and maybe a slightly higher risk tolerance for markets, I might choose to compare my current debt instead to the historical return on the SP 500 that I could invest in through a low-cost index fund or exchange-traded fund.

And the SP 500, since its inception, has averaged 7% to 8% per year post-inflation.

That means in real terms.

If your debt interest rate is significantly below that, the argument for investing early instead of repaying gets even stronger than it did when we compared it to the 10-year.

And that's even after tax considerations.

Take a 3% mortgage, for example.

If you have 30 years to invest, history suggests that putting extra money into the market instead of rushing to pay off your home could leave you with a much, much larger net worth after 30 years.

But here's where I'm so glad I'm sharing this via podcast, because there is a boatload of nuance that we need to continue to explore.

First, investing in the stock market is not ever a guaranteed return.

Just because history shows us what the market has returned doesn't mean anything really about what the market will return.

It's just our best collective guess based on the data we have.

Additionally, the markets are highly volatile from one year to the next.

So if you are heading into retirement with this debt, or you need to pay down the debt in the next few years to rely on a steady 7 to 8% return from the markets is just absurd and would be taking on too much risk for, well, most of us.

But the overall point is this.

Paying off low interest debt is a guaranteed small win, while investing in either the risk-free asset class or the stock market or other asset classes of your choosing is an opportunity for a much bigger win, especially over time.

If your debt is sitting at 7% or higher, the decision flips.

At that point, the return on paying it off is roughly equal to a guaranteed return on the market's average return.

And that, to me at least, would simply be very much worth prioritizing.

So now you might be asking, well, let's say I have a few types of debt.

Which debt goes first if I have decided to pay some down?

As should be clear by now, not all debt is created equal.

Some debt might be merely inconvenient, let's say a 2% mortgage, God bless you who have those, while other types can be outright dangerous to your and your family's financial stability.

The key is knowing which is which and tackling the danger zone immediately with anything and everything you can.

The biggest financial emergency by a long shot is credit card debt or any debt that carries an interest rate over 8%.

And the average credit card APR today is well over 20%,

meaning that if you're carrying a balance, you're essentially burning money.

I can't drive this point home more clearly.

If you're carrying a debt of 20 to to 30%,

you're literally burning, well, not literally, you're burning money.

And I don't say that to judge you by any stretch.

And I don't say that assuming you should be able to magically have the debt disappear, but it is 100%

your priority.

Now I'll pause once again here because I have listened to a few mega self-proclaimed money experts suggest that before anything else in your life, you should establish an emergency fund and fund that with three to six months of cash.

Even in a high-yield savings account, earning 5%,

if you're putting any extra income into that savings account, well, you have a debt of 20 to 30%.

Just know you are still coming out negative at year's end by a long shot because your net outflow is still between 15 and 25 percent.

A plus five at year's end, even if guaranteed, does not justify a negative 15 to negative 25 outflow at year's end.

You have no business opening an emergency fund if you have credit card debt.

That debt is your emergency, first, last, and always.

And every month you hold onto that debt, it compounds against you at a rate that no investment can realistically beat.

Paying off credit card debt is like getting a guaranteed 20% return on your money.

There's quite simply no better opportunity out there, particularly a guaranteed one.

Now, those first two categories are actually relatively easy to me.

And I think to you, they're pretty objective.

If debt's below the risk-free rate, adjusted for taxes, let it ride.

If it's above 8%, pay it down right now.

That's your emergency.

But what about that pesky middle zone?

You know.

The student loans, the personal loans, well, maybe not today.

and the auto loans, which tend to range from 5% to 7%.

These aren't emergencies, but they're not exactly harmless either.

If you have federal student loans under 5%, for example, aggressively paying them down might not be as urgent as investing for long-term growth.

On the other hand, if your student loans or personal loans carry rates above 7%, you're creeping into the territory where prioritizing payoff makes a lot of sense.

But ultimately, the 5% to 7% zone is the zone where you simply need to know thyself.

More than in any other zone.

Are you relatively young with a long time horizon and a high risk tolerance?

Or are you heading into retirement, losing an income stream, and terrified of lingering debt payments?

There is no one size fits all, and I have many friends who respond drastically differently to this pesky middle zone.

You need to understand who you are.

You need to do the real work of knowing how you respond throughout life to debt so you can figure out if you are a pay down the 5% to 7% type of person or a let it ride and hope for the best type of person.

To recap, when deciding what to pay off first, one, if your debt is over 8%, it's an emergency.

Get rid of it right now.

Two, if it's 5% to 7%, it's a judgment call.

It's a psychological call.

Pay it off if you prefer guaranteed returns, but invest it if you're an opportunist with some additional cash flow options.

Number three, if it's under 5%, honestly, that's debt I want people to learn to be okay with.

Your money is likely better off elsewhere and will ultimately work harder for you elsewhere.

But even though numbers can guide us to an extent, debt isn't, as I've already said, just a math problem.

It usually is anything but a math problem.

And we aren't logical beings responding to columns on a spreadsheet.

We're irrational ding-a-lings responding to our emotions on a daily basis.

And usually we don't do it too well.

Some people can carry debt strategically and still feel emotionally strong and stable, while others hate every single thing about the concept of owing money, even at low interest rates.

And here's the thing.

It doesn't matter which which camp you fall into as each are equally valid, and you should never let someone tell you otherwise.

Debt has an emotional weight that can't be measured and overcoming decades of debt can be one of the single most empowering moves you could ever make, even if it's a 2% fixed mortgage.

For many, the burden of owing money causes stress, anxiety, and even shame.

So if you're someone who lies awake at night thinking about your loans, then there's a case to be made for prioritizing paying it off, even if it's not the absolute best financial decision on paper.

Who cares?

If you can't sleep, that sucks.

So this is where it's worth mentioning two different practical approaches that might or might not work for who you are at this point in time, the avalanche method and the snowball method.

The avalanche method is mathematically optimal.

Pay off the high interest debt first, like I mentioned above with the credit card debt.

So you minimize the total interest paid.

Now, personally, I don't know how you don't choose this one.

This is without a doubt the smartest thing to do financially, and to allow credit card debt to accumulate is simply a surefire way to never get out of debt.

But eating my own words, seriously, if this is not your preferred method, you might try the snowball method.

The snowball method focuses on momentum and prioritizes the emotional impact of getting rid of a debt altogether.

thus paying off the smallest debts first to get quick wins and build motivation.

And there are studies that show that while the avalanche method saves more money, the snowball method works better in practice for many people because it keeps people engaged and committed.

And hey, anything that gets you paying attention to your personal finance works for me.

I support it.

Let's go.

And both of these methods tie directly into what's called the freedom factor, the feeling of being completely debt-free.

And that is genuinely priceless.

While some financially savvy individuals choose to carry debt strategically, others prefer the absolute clarity of owing nothing to anyone.

I cannot tell you how many former clients I had who would start the conversation with a massive grin on their faces, telling me that they owed nothing to anybody.

Car was paid off, home was paid off, everything was paid off.

Even if that was the extent of their net worth, they were so happy and who the heck was I to tell them otherwise.

Don't ever underestimate the feeling of being beholden to nobody but yourself.

The key again is understanding your own comfort level with debt, your own place in life and income streams, and making decisions that align with your personal risk tolerance.

So a few final takeaways for this part of the discussion.

Paying off debt versus investing comes down to a few key factors.

Number one, compare your debt rate to available investment returns, the opportunity cost.

Number two, credit card debt is financial fire, blah, blah, blah.

I've already said that.

Number three, know yourself.

Unfortunately, this isn't actually as simple as we all make it sound.

So sometimes you actually have to go into debt in order to understand how you actually feel about being in debt.

Public service announcement, I do not endorse your going into debt simply for the feeling, but kind of actually I do.

No, I do.

I err on the side of saying, you know what, if it's a couple bucks in debt just to get the real feeling, not a bad idea.

Number four, balance is key.

Odds are you don't want to be debt-free and broke.

A well-rounded plan involves some debt payoff, some investing, and making sure that you are always able to go out and enjoy the occasional sub at Jersey Mike's with extra bacon.

And those are not cheap these days.

At the end of the day, there's no one size fits all answer, no one gets rich paying off a 3% mortgage early, but no one sleeps well with 20% credit card debt either.

It's about finding the balance that works for you, both financially and emotionally.

So up until now, we've talked about debt as something to be eliminated, or at least managed wisely.

The latter part of this episode will take on a slightly different tone as we will now look at the other side of debt, a side that the wealthy understand well and frequently use to their advantage.

It's called leverage.

While most personal finance advice focuses on avoiding debt or getting out of debt, high net worth individuals and successful entrepreneurs often embrace debt strategically.

They use other people's money or OPM to create opportunities that wouldn't be possible with their own cash alone.

Now, I'll even pause here to make sure we understand that I devoted the entire first part of this episode to making sure we understand the importance of paying down debt.

I am not now advocating that you throw it all to the wind and go borrow someone's money if you want to be rich.

However, if you are a strategic thinker with a specific skill set and an entrepreneurial drive, OPM is a concept that you would be remiss to go through life without understanding.

And if the time is right, taking full advantage of.

The best example of a time when leverage is a very smart idea is in starting or scaling a business of your own that you believe will be successful.

Take a look at some of the most successful companies currently, Apple, Amazon, Tesla.

They all took on massive amounts of debt to grow.

They borrowed money to build something larger than they would have been able to build themselves, understanding that if they played their cards right, the rewards could far exceed the risks.

This is called the asymmetry of opportunity.

Yes, there was a downside, but using other people's money to offset some of this downside, the upside now scaled to astronomically higher potential returns.

Leverage allows you to take on bigger risks without solely using your own money.

And that's a good thing.

Of course, leverage isn't for everyone, and it carries significant risk, but when used strategically, it can be one of the most powerful financial tools available.

And one of the things I like most about leverage is that it shifts our defensive view of debt to a highly offensive view of debt.

The wealthy tend to see debt as a tool for multiplication rather than just a liability.

Instead of thinking, how quickly can I get rid of this debt, they ask, what can I do with this capital that will generate a higher return than the cost of borrowing?

Now, that's not easy.

And if we could all figure out how to return over 20% on someone else's capital, well, more power to us.

But let's consider real estate investors.

A typical investor might buy a rental property using only 10% of their own money, if that, and financing the other 90% with a loan.

If the rental income covers the mortgage and expenses, while the property appreciates in value, that investor has turned a small amount of personal capital into a much larger ultimate return.

This is leverage at work, using borrowed money to create strategic wealth.

Business owners do the same.

Imagine someone with a great idea, but not enough capital to fund it.

Perhaps you've seen Shark Tank.

I love that show.

where multiple aspiring entrepreneurs ask the sharks for money so they can usually grow the business without taking on additional risk of their own.

These entrepreneurs can take out a loan, bring in investors, or seek venture capital.

If the business succeeds, the borrowed money has multiplied their return far beyond what they could have achieved alone.

But if the business fails, again, the risk was not theirs alone.

For me, one of the most overlooked benefits of leveraging other people's money is risk sharing.

When you take out a loan to start a business or invest in a project, you're not taking on the full risk yourself.

The risk is now shared with the lender or investor.

Compare this to putting your entire personal savings into a startup.

If it fails, you lose everything.

But if you borrow capital from investors or banks, the risk is distributed.

Mitigate the downside, multiply the upside.

Of course, lenders expect repayment, but in many cases, such as business loans, the structure of the deal allows entrepreneurs to take calculated risks without putting their entire net worth on the line.

This is why successful entrepreneurs and investors embrace leverage while the average person avoids it.

They understand that in the right circumstances, taking on debt can create asymmetric upside, a potential for gains that far outweighs the downside risk.

But once again, leverage is not a free pass to reckless borrowing, nor do I bring it up to encourage anyone's using it in such a way.

There are smart ways to take on debt, and there are incredibly dangerous ways to take on debt.

Here's when it makes sense to me.

Number one, when the potential return is significantly higher than the cost of debt.

Again, back to our early notion of opportunity cost.

If you were able to borrow money at 5%,

and you're usually not, but if you were, and you could expect a return of 20%,

that could be a pretty reasonable risk for you to take on.

Number two, when you have a clear plan to generate cash flow.

Debt should be taken on with a specific revenue strategy in place, whether that's growing a business, real estate rental income, or another another income generating investment.

Number three, when the risk is distributed.

Using investor capital or structured loans can help ensure that no single failure wipes you out altogether.

And in the ever-wise words of Mikey McDermott from Rounders, always leave yourself an out.

Where it doesn't make sense to use leverage is when debt is taken on without a plan or for something that depreciates in value with no return, like high interest consumer debt on luxury purchases.

And good news, odds of your finding someone to lend you that money for those types of expenditures are officially zero.

Final thought.

Debt is a tool.

It's not a trap, but I understand why we view it that way.

For many people, debt feels like a burden, but in the right hands, it can be an incredibly powerful tool.

The key is knowing the difference between good debt and bad debt, between borrowing for consumption and borrowing for growth.

And if you are borrowing for growth, to know what you're getting into and to have the right plan in place.

Start small.

If you're using debt to invest in your future, whether that's building a business, buying an appreciating asset, or funding an opportunity that has the potential to far exceed the cost of borrowing, it can be a lever for wealth building rather than a liability.

And in a follow-up episode, one of the case studies that we will analyze is the cost of college currently and whether or not you should take on, as a young adult in our world today, a 200 to quarter of a million dollar loan to get a bachelor's degree.

We'll analyze that versus what else you could do with the money, especially in an ever-changing technological landscape with more and more access to free resources.

The trick is always making sure the upside outweighs the risk.

That's true for leverage, that's true for thinking about consumer debt, and as I mentioned at the beginning, thinking about the opportunity cost is one of the most important things you can ever do moving forward.

And now that I've spent a portion of my day sharing it with you, The opportunity cost was walking my dogs, and I'm going to go share the remainder of the day walking the hounds in the woods of Vermont.

Thanks for tuning in to your money guide on the side.

If you enjoyed today's episode, be sure to visit my website at tylergardner.com for even more helpful resources and insights.

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Until next time, I'm Tyler Gardner, your money guide on the side, and I truly hope this episode got you one step closer to where you need to be.