As you reach certain milestones in your life, you may be faced with the opportunity to pay for things with loans and accumulate debt. It’s not always a bad thing. Sometimes you have another term at college, a big purchase, a new family member, or life just throws you a curve ball. No matter what the cause, there are different types of debt and ways to pay them off. Jose Torres, Interactive Brokers’ Senior Economist, joins Cassidy Clement, Senior Manager of SEO and Content to discuss.
Summary – Cents of Security Podcasts Ep. 33
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Cassidy Clement
Welcome back to the Cents of Security podcast. I’m Cassidy Clement,Senior Manager of SEO and Content at Interactive Brokers. Today, I’m your host for the podcast. And our guest is Jose Torres, Interactive Brokers’ Senior Economist.
As you reach certain milestones in your life, you may be faced with the opportunity to pay for things with loans and accumulate debt. It’s not always a bad thing, though. Sometimes you have another term at college, a big purchase, a new family member or life just throws you a curveball. So, no matter what the cause, there are going to be different types of debt and different ways to pay them off. Today we will discuss those types and welcome back to the program, Jose.
Jose Torres
Great to be here, Cassidy. Thanks a lot.
Cassidy Clement
Sure. So what are some of the common ways that people accumulate debt? I know in America it’s pretty common to hear the word thrown around; debt or loan or owing money, but what are those common ways?
Jose Torres
Generally speaking, two ways that I think about it are using debt as a helpful tool or investment. And another way is to use it to fuel consumption. For example, at times when home prices are reasonable and interest rates are modest, using mortgage debt to buy a house can make sense, especially when the combination of interest costs, principal payments and house maintenance costs are lower than the cost of renting.
In other instances, consumers can accumulate debt to purchase cars and also for emergencies. Consumers can also use credit cards as a convenience when shopping and making travel arrangements. Credit cards are great if you pay them off before the interest begins to accrue because it could be viewed as a trap. If you pay them off before the interest begins to accrue, oftentimes you’ll have rewards, points, all kinds of different benefits. In some cases, these benefits range from 1% to 6% of what’s spent. Depending on what card, what terms, all those kinds of things. In contrast, however, interest rates on credit cards can sometimes be over 20%, right? So if you’re getting the points but you’re paying the interest, you’re still negative by a lot. So another way people accumulate that is to increase their living standards beyond what they could afford with just their income. Debt, at least temporarily, allows individuals to spend more than they earn. Eventually, however, the debt payments can become unsustainable, causing these individuals or households to default on their debt payments or significantly cut their quality of life, which can be painful in another way.
Cassidy Clement
So it seems that, as you mentioned, there’s a few different reasons that you can run into somef type of debt accumulation. You may end up, like you said, overuse of your credit card job loss education. Expenses having children maybe of a business fail. But within all of that, you know, sometimes initially people think about it and they’re like, well, I don’t want any debt at all, but. As you said, if you pay it off at an accurate rate or before you’re technically accruing interest, it can be a positive because you can start to establish credit and so on and so forth. So there could be some some good debt such as like furthering your skill. If it’s education or your equity in something like a home.
But then there can also be not so good debt. Like you said a lot of it is like consumption almost. You know, the people who really may buy the super expensive shoes and they don’t actually need them. Or can’t actually afford them without accumulating a lot of interest on a payment for a card or something like that.
So are there other types of debt? Is there good debt and bad debt in? In a grand scheme, is there.. I know I’ve heard the phrase secured or unsecured debt. What are the different types?
Jose Torres
Sure. So the debt that I like is debt that fuels an investment where the return is much greater than the interest rate. For example, if you’re going to get a return on your capital, or on the debt, rather, of 20%, but the interest rate is only 6%, then you’re walking away with 14% after you account for the debt payments.
So corporations do that frequently. Their return on invested capital could be 15%, 20%, 25%. And their cost of debt may only be 6 or 7%, right? So they’re going to make that difference. If they don’t use any debt at all and just use cash, then those excess returns that they would have earned via the debt aren’t earned at all. They just don’t exist. We have an economy that really relies on debt a lot. How could you buy a home if you’re in the middle class without assuming a mortgage unless you had a big inheritance, right? How could you? Average price is somewhere in like the 300-400,000 range. Auto loans too. Autos are expensive, especially now we’re moving into electric cars. Electric cars, a lot of them are $25,000 at the cheapest. A lot of people don’t have $25,000 to just drop without taking on the debt. A lot of people don’t have $2000 just laying there, so in some cases the economy kind of pushes you into taking on debt. Otherwise you cannot participate in electric vehicle ownership or home ownership.
And I think that in many cases it’s very useful and it’s a great benefit of our system. In other countries, many others, you can’t finance a property, a home over 30 years. You know, it’s more like 15 years, maybe 10 years. Some places only five years. And that also contributes to prices being a lot higher. Debt eventually does become inflationary if there’s too much debt in an area. So like real estate became really a levered kind of asset class. And because it became so levered, prices went up significantly.
Similar to; a little bit unrelated, but what happened following the pandemic recession, following COVID. We took on a lot of debt. The central bank monetized it by buying the debt, and we had inflation. So that’s a little bit of a different angle than what we’re talking about. The general topic of the podcast. But I think it’s an important point.
Cassidy Clement
Yeah. So you had mentioned with a mortgage, so obviously, at least in the United States, you’re looking towards that for some type of a secured debt that would be used to purchase real estate. A lot of our listeners will probably be familiar with revolving debt, which is something like your credit card. You pay it off and then it replenishes. The secured debt is something that is collateral backed by collateral, where unsecured.. It’s basically just looking at the debtor’s income, their credit profile and some other things involved, but there’s really no collateral. So really, if you’re looking for a bit of a litmus test of what’s good and what’s bad, generally, as we mentioned before, you’re going to want something that can allow you to gain something, whether it’s the home over 30 years or the skill of an education degree, something like that.
But if there are higher interest rates, which I think you used that exact example for and it’s not accurate to what you can actually gain from it, it might not actually be a positive debt to take on because it may actually be more of a headache than it’s worth in the end.
Now when we talk about in a general sense, paying off debt. Most people will say, okay, well, I try to pay off as much as I can, but maybe I’m only hitting the minimum of what I can allocate this month. Or maybe I can only pay once a month. But some tips are obviously, if you can pay more than the minimum, awesome. If you can pay more than once a month, great. And if you have the most expensive loan out of your batch debt, obviously the one with the highest interest rate or the most expense is probably the one that you would like to finish and pay off first. But some methods that people have mentioned, whether it’s in research or any type of personal finance literacy items, it’s some things such as an avalanche versus snowball methods. Avalanches, you’re making minimum payments, but then you’re eventually using any extra funds to pay off the debt of the highest interest rate. Where then the snowball method is you make minimum payments on all of your debts. And then you’re paying off the smallest debt before moving on to the bigger ones. So some may argue that the Avalanche method can result in paying less interest over time, but it’s really based on what your scenario is and what is your target number on each of these debts.
So with all of that in mind, how would one in a general sense, how would someone from your perspective be like, okay, this is how somebody would go about paying off their debt if they had somewhat of a portfolio of debt? Especially in today’s market, I think that’s pretty fair to say.
Jose Torres
I’ll answer that question and then I want to talk a little bit about student loans. So I didn’t get a chance to talk about them. So how does one pay them off? Cut expenses, boost income, right? That’s the simple way. It’s an uncomfortable way, for sure, but, that is the simplest way to do it, right? And in some cases some folks may say, well, you know what, that appears insensitive. What do you mean “boost my income”?
Well, we have a dynamic economy these days. There’s Uber, there’s DoorDash, there’s Task Rabbit. There’s so many different applications and verticals where one can make extra money maybe working one or two or three extra days a week. Maybe just a few hours, right? That’s a way to increase income. Oh, well, how about my expenses? If you really take a good look at your spending habits- we have a very high quality of life here in America. Granted, we have global listeners and hello to all our everyone around the globe, not just the United States. But not just America, but developed nations have a very high quality of life, where cutting expenses is a lot easier than if you’re in an emerging economy where almost all of your money goes to staples, not discretionary services or items, right? Well that’s actually an integral point, right? We in the developed world have such a high quality of life that the economy has totally transitioned from goods to services. We spend almost everything on services, not on goods. We don’t actually need any stuff. Stuff is cheap for us. It’s just services that are expensive, right? So focusing on cutting the services, I think is a creative way to pay off debt and using that money for debt service. Debt consolidation is a more practical way. Finding a finance institution. These are pretty popular, where they’ll take all your credit card debt or other debt that you have, and they’ll combine it into one and they’ll lower your interest rate significantly in some cases from 20% down to 12%. So that’ll lower your interest a lot, but you don’t have the flexibility. Oh this month, I’m just going to make a monthly a minimum payment. Next month I’ll make minimum payment plus $300.00, right? You don’t have that option. They’re going to hold you to make a specific payment every single month.
If I may turn to student loans. And the earlier discussion that we spoke about with debt, student loans became very popular. They started to significantly drive up the price of education and in today’s society, a lot of folks are starting to question whether it’s even worth it and to some to some degree, they’re right, although I’m a huge advocate of going to college and getting an education. I just think that focusing on the right things while you’re in college and the right areas of study that are directly linked to today’s economy and what jobs we have out there, I think that’s important, right? There’s a lot of partying going on in colleges. There’s a lot of hanging around. It’s not a country club, right? You’re taking on debt to hang around. That’s not good, right? Taking on debt to really become a productive member of society. I think that’s a much better scenario for the person, for the debt service and for society as a whole.
Cassidy Clement
So when it comes to college, I couldn’t agree more because college is so expensive and at a young age, some people are an early birthday. They’re heading in at 17. And they really don’t realize just how much that cost is going to be as the years go on. If you’re lucky, you may not have to pay a large sum, etcetera, but it can be a big deal, and that debt can follow you for a lot of things.
Jose Torres
You know, Cassidy, I would add; I was at the forefront when I used to work at the Department of Labor, what we labeled a mismatch in the labor market. Recently, since COVID, we saw a dramatic increase in job openings in the US. But we in the Labor Department, we’re seeing it back in 2017 through prior to the pandemic, through February 2020.
We had so many job openings and companies just had so much trouble right sizing. What do we need? What’s the supply of workers like right there? There was just a mismatch there, and that mismatch shouldn’t exist if our whole society… Let me rephrase that. If a huge percentage of our society is taking on debt to go to college and in some cases, upwards of 200 grand, right? Why do we have a labor market mismatch? Why are these students not taking on 200 grand debt to then be directly linked to an employer, right? Why aren’t they doing the work before taking on the debt? Is the debt being given to them too easy? Should there be a survey or a test before they take on the debt? Right? Allocating the path of the student with the path of the economy and the path of what corporations are doing. Right? And I think that we need to make strides in that direction. Even today we have a huge amount of job openings. I think we’re at around 8 and a half million, 9 million, albeit we have a low unemployment rate. But if those job openings all get filled, not all, right? They can’t all get filled but if they get cut let’s say 30% or 40%, now we have a significantly more productive society because companies have the skills that they need and they can get more things done, produce more goods and services, leading to a higher gross domestic product, that eads to a higher quality of life. For everyone in aggregate.
Cassidy Clement
It’s an interesting point. I do think from a statistics area there may be a misallocation when it comes to the debt being provided or I will say the debted funds being provided to the new entrants to college, as in comparison to the potential salary that they can make in the time frame that is expected for them to make good or pay back on the debt.
And the reason being is there are so many universities and etcetera in this country and plainly saying it, it’s not cheap and not every degree is going to yield sometimes six figures of debt that has been incurred almost instantly for people to make well on their loans over the next 10 years. But on that, are there some ways that are better for people to pay back their debt than others? Because I’m sure there’s some people out there with some credit card debt, some people with student loans, house loans. All three, who knows?
Jose Torres
Yeah. So some debt is tax deductible like mortgage interest payments. So there’s an incentive to pay that debt off more slowly, whereas some debt really pressures you in the short term like credit card debt. So in those kinds of scenarios analyzing the tax implications of debt payments is very important. But generally speaking, to your earlier point about the avalanche, paying off the highest interest debt first is the best way to go, generally speaking.
Cassidy Clement
So you kind of mentioned this a little bit with the mortgage item, but are there certain types of debt that are better to pay off first in general? So let’s say where somebody who doesn’t have a mortgage payment, what would be something that maybe a little bit more along the lines of.. Some people say what the best thing for me is I’ve got to look at the interest rate and see maybe I go with the first one first, maybe I go with the smallest one. The debt repayment generally is based on circumstances. But I was just curious if there are some ways or some items that are better to pay off than others?
Jose Torres
Yeah. I mean, generally speaking, it’s really all about the highest interest debt first because what happens is that whatever your interest costs are every month, if you pay the highest interest debt first, incrementally month after month after month, your debt costs start to go down. And eventually if that’s what you want, they’ll get to minimal or even 0. If in the case if you don’t have a mortgage, right? So that’s really the way to go, I think is the highest interest rate debt.
Cassidy Clement
So then you mentioned a few questions ago about evaluating spending habits. So that may be the first and probably the most intuitive thing for people who take on debt to do if they believe that they’re getting a little in over their head. But are there certain tools that can help people pay off debt or considerations?
Jose Torres
Yeah, I think automatic payment services are great because they automatically take the money out of your checking account, your savings account. I think that’s a great way to pay down your debt without having to press a button. It’s just automated. And to our earlier point, the credit card consolidation is a great way. Also maybe calling your bank and maybe trying to negotiate with them. Hey, can you lower me at my interest rate? Can you maybe not charge me interest this month? That’s another thing that’s not the most convenient or most comfortable angle, but it’s something that can certainly help.
Cassidy Clement
And it’s also worth mentioning, today’s day and age, sometimes people just need a little bit more organization and reminders in their life. I know that in the grand scheme saying that out loud, somebody may say oh Cassidy, that’s all well and good, but I if I have 5 grand in debt, I don’t really need somebody just telling me hey, pay my debt.
But as you mentioned with hey this month, maybe reevaluate your interest rates or call your bank. There’s a lot of debt pay off, planner type applications, mobile applications that can help different people depending on your circumstance, plan out maybe the budgeting potential calculations of how different payments can offset the cost. And also just to be organized about your finances in the sense of where you’re at. You don’t want to find out that it’s not working out for you by a not-so-great credit score. Being on top of it and being aware of your finances and your own information, you’re entitled to know about it. So definitely staying on top of things would probably be the most advantageous.
Before we closeout, are there any other pieces that you have for our listeners who are starting to get into their financial independence when it comes to taking on debt?
Jose Torres
Yeah, I would add that writing things down is great because you’re moving your hand and you’re thinking about what you’re writing down and you’re seeing it, right? That’s the way of organizing your thoughts and your finances and really seeing the progress day after day, week after week, month after month. And writing down goals as well. But I think overall I think I covered most of what I wanted to cover in this podcast so far.
Cassidy Clement
Great. Thanks so much for joining us, Jose.
Jose Torres
My pleasure. Thanks for having me. And I look forward to the next episode. Thanks, everyone.
Cassidy Clement
Awesome. Thanks. So as alwcays, listeners can learn more about an array of financial topics for free at ibkrcampus.com. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening everyone.
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