Debt

Managing debt tends to stress people out. Seeing large sums of money you owe compared to a small checking account is daunting. The good news is, if you're in debt, there are ways out. If you're not in debt, then there are ways to avoid it.

But before we get into the nitty gritty of paying down debt, we need to pin down why debt holds you back. It all comes down to one simple reason: opportunity cost. Opportunity cost is the theoretical amount of money you are losing by using your money one way vs. using it another way. When considering debt, the opportunity cost is the money we're losing from paying interest instead of investing that same money.

Remember, interest rates are a bank's way of charging us to use their money, and as it turns out, it's very expensive. Especially when we consider how else we could be using that money.

Opportunity Cost Example: Car Loan

Let's say you go buy a brand new Honda Civic for $20,000. With good credit, you should expect to get a loan at a 4% interest rate with a term of 60 months (you'll be making monthly payments for 5 years). Over the life of the loan, we should expect to pay $2,100 in interest.

Over 5 years, an extra $2,100 really doesn't seem too bad, right? Well sure, until we consider the opportunity cost. The S&P 500 index, the longest running average of the stock price for the top 500 US companies, has grown about 11%, on average, per year. For any investment into the index, we should expect to see an average 11% annual growth of our original investment, not every year, but over the long haul.

So let's compare. If we invested $2,100 into the S&P 500 for 25 years, we could expect that investment to be worth $28,500 in 25 years. Even accounting for expected inflation, that's about $14,400 in today's dollars. Now we see that that car loan is much more expensive than just the $2,100.

It's opportunity cost that motivates us to pay off debt quickly and then start investing.

Not all debt is created equal, and some loans may give you something that you're willing to work to pay off. But in general, avoiding debt is best, especially loans used to buy a depreciating asset (like a car). In the deep dive, we'll discuss different types of debt, which types to consider, which to avoid like the plague, and how to prioritize paying off the debt you have.