When I first started on my personal finance journey years ago, I was 100% in agreement with everything Dave Ramsey taught. I was firmly anti-debt, swearing off any type of loan, no matter its rate or purpose. I was only ever going to pay cash for a car. I told myself that when I have a house, I was only going to take out a 15 year mortage and I would try to pay it off as quickly as possible.
As I progressed in my journey and we solidified our long-term goals, however, I’ve come to believe that debt isn’t really as black-and-white as I once thought. As heretical as this would sound to myself a few years ago, I don’t think all debt is bad if it’s used responsibly and if it is in line with long-term financial goals.
You see, in our current post-recession economic climate, the Federal Reserve has kept interest rates for Treasury bonds intentionally low in order to stimulate the economy. Interest rates on things like car loans and mortgages are based in large part on these Treasury bond rates, so we’re seeing some of the lowest interest rates in recent history for many types of loans.
What does all of this mean for us as individuals? Well, it means that the decision about whether to pour loads of cash into big purchases is less cut-and-dry. The reason is that opportunity cost is a much bigger factor for consideration now. Opportunity cost is the loss of potential gain from alternative choices when one choice is made. If we apply this concept to the purchase of a car, let’s imagine that you were going to buy a $15,000 used vehicle. You could pay $15,000 in cash to purchase the car outright, or you could take a loan with a $3,000 downpayment and a 2% interest rate for 4 years. The average expected rate of return for index funds in the stock market is around 8%. So, if I take the cash I would have put toward the car and instead invest it in the market, I can likely get a 6% greater return on my cash.
There are, of course, some caveats to this way of thinking. First, you must have enough cash on hand to cover emergencies like a job loss or major car/house repair. If you take on a car loan or a mortgage that completely depletes your cash reserves and then encounter an emergency that costs several thousand dollars, you’re going to end up financing your emergency with high-interest debt, completely reversing any advantage you might have gotten. Secondly, if you’re not actually investing the difference in the market, then this approach is nothing more than an excuse to spend more.
In my case, my future plans involve reaching financial independence at as early an age as possible. Because of this goal, the future value of our cash is more valuable than 2%. So, I’m okay with not paying down our 2% car loan if it means I can instead invest that cash in the market and build a bigger nest egg more quickly.
I do find myself flip-flopping a bit on this whole thought process, as there is a definite psychological win in having a paid-off house.
What do you think? Where do you fall on the debt-aversion spectrum?