High-interest debt will crush you.
A hyperbolic statement? Perhaps, but not by much.
If you haven’t yet read through the four posts on emergency funds (1, 2, 3, 4) prior to getting to this post, you should, because everything I’m going to say here about high-interest debt assumes that you’ve built an emergency fund of at least $1,500 and that you understand everything you need to know about your emergency fund.
If you haven’t built an emergency fund of at least $1,500 yet, then you don’t yet need to turn close attention to your high-interest debt (other than to stop adding to it, if you haven’t already). You’re still welcome to read this post, of course, but you don’t need to start implementing anything from it until your $1,500 is in place.
According to Experian’s 2019 Consumer Credit Review, the average credit card debt for Americans is $6,194. According to the Federal Reserve’s consumer credit data, the average interest rate on credit card debt in 2019 was 15.05%. When you put those two statistics together, you realize that many Americans have a big, big problem.
Here’s the bottom line on high-interest debt: It’s bad. Really bad. I would be doing you, the reader, a disservice if I told you anything otherwise.
But at the same time, I’m certainly not judging you if you currently do have high-interest debt, regardless of how you got there or how much it is. Because the truth is, it doesn’t really matter exactly how you got to that point, if you’re there.
What matters is recognizing that you’ve got to get out of high-interest debt as quickly as possible and stay out. Your high-interest debt has got to go, and it’s got to be prioritized in order for you to get anywhere financially.
What is high-interest debt exactly? How high is “high”? For most of us, we have to incur at least some debt in order to purchase a home. In many cases, we may also have to incur debt to purchase a car. For many, a car is a necessity, as is a home, if one does not rent his or her dwelling. Many of us incur debt from student loans as well.
So yes, some debt is largely unavoidable. But in the case of a home, used car, and student loans, the interest rates on each of these debts isn’t considered “high-interest” (or shouldn’t be, assuming a non-disastrous credit score). So what’s “high-interest” debt?
I would classify high-interest debt as any debt with an interest rate greater than 6%, because the average student loan interest rate is right around 5.8% (as of September 2020) and because the average used auto loan for someone with a good credit score (say, 650 or higher when referencing auto loans) is going to be below that 6% threshold as well (as of September 2020).
But there’s an additional reason to consider debt with an interest rate greater than 6% as high-interest debt, and that has to do with investing, specifically. I won’t bore you with the technical details, but going forward for about the next decade, most analysts at most financial firms believe it’s going to be unlikely that U.S. stock market returns will exceed 6%, especially when talking about a properly diversified portfolio across U.S. stocks (a total U.S. stock market index fund, for instance).
For example, in Vanguard’s most recent economic outlook (July 29, 2020), Vanguard analysts indicate that they expect nominal (not adjusted for inflation) U.S. stock returns to be between 4% and 6% over the next 10 years.
Why does U.S. stock returns likely not exceeding 6% over the next decade matter when talking about high-interest debt? It matters because if you carry high-interest debt, your debt will often be overtaking anything you think you might be accomplishing on the investment front, especially the higher the debt to investments ratio becomes. Let me illustrate this with an example:
Let’s say I have $10,000 saved in my retirement account in January of this year, I don’t contribute any more to it this year, and at the end of the year, I will have earned a 4% rate of return on it from having it invested in a risk-appropriate, well diversified portfolio. So I earn $400 in my retirement account in 2020.
But let’s say that in January of this same year, I also have exactly $10,000 of credit card debt on my card, that the interest rate on my credit card is 18%, and that I won’t add to that debt at all through additional purchases for the entire year.
Let’s say the card’s terms say the minimum monthly payment is 2% of the balance. For my first month, the interest charged will be $150 ($10,000 x .18 = $1,800 — $1,800 / 12 = $150), bringing the total owed to $10,150. 2% of $10,150 is $203, so my minimum monthly payment is $203. I decide that I can afford only the minimum monthly payment, so I pay the $203.
(A quick note here that though I simplified for my example, most credit card interest actually compounds daily rather than monthly, which makes credit card debt especially nasty.)
That’s bad enough as it is, right? Only $53 of my payment is going to principal, with $150 going to cover the interest.
But it’s even worse than that. Why? Because of what’s going on over in my retirement account. Remember how I would be earning $400 in investment return in my retirement account for the entire year? Yeah, that’s for the entire year, but I just paid $150 in interest on my credit card for one month.
Do you see where this is going? In month two, my balance is now $9,947. For this month, the interest charged will be $149.21, bringing the total owed to $10,096.21. 2% of $10,096.21 is $201.92, so my minimum monthly payment is $201.92. I decide that I can afford only the minimum monthly payment, so I pay the $201.92.
$52.71 went to principal, $149.21 went to cover interest.
In one year, I earn $400 in investment return in my retirement account. In two months, I pay $299.21 in interest on my credit card.
In just two months, I’ve come very close to offsetting my entire investment gain in my retirement account for the whole year. In month three, as I’m sure you’ve realized, I actually overtake my investment gain in what I pay in interest on the credit card.
But guess what? It’s actually even worse than that.
What? How?
We haven’t yet factored in the cost of not being able to invest what we could have invested, were we not paying all of that high interest. So if we pay around $1,750 in interest for the whole year (I don’t have time to make an exact calculation for every month as the balance slowly decreases with minimum monthly payments, so let’s just say $1,750 for simplicity), that’s $1,750 that could have been invested were we not paying it in interest.
What this then means is that instead of having our $10,000 that earned $400 at a 4% return for the year (we’ll pretend it compounded at .33% every month), we could have had the initial $10,000, added a $145.83 ($1,750 / 12) monthly contribution, and ended up with $12,191.22 at the end of the year instead of $10,400, a difference of $1,791.22.
Not only was our $400 investment gain quickly swallowed up by the interest we paid, but we also missed out on investment gain we could have had. Ouch.
But, of course, all of the above assumes an existing $10,000 retirement account balance in the examples. Many of you reading this post have never invested anything at all. Others have invested far less than $10,000. As I said above, the higher your debt is relative to the balance in your investment account(s), the bigger this problem becomes.
So let me boil everything down to this if you find yourself in the position of a high debt to investments ratio or you’ve yet to invest anything at all:
Do not invest until you have paid off all high-interest debt.
Please listen to me: Don’t do it. So long as you carry high-interest debt, whatever you’re doing in your retirement account (aside from taking your employer’s free money in the match, if offered, because we never leave free money on the table) or whatever you’re doing with other investments likely will not matter at all if you’re having to pay such high interest on the other side of your finances.
If you continually carry high-interest debt, you’ll likely never get anywhere with investing. And if you never get anywhere with investing, you likely won’t be able to reach your financial goals.
A $10,000 retirement account balance and a $10,000 credit card balance? Not good, as I illustrated.
A $1,000 retirement account balance and a $10,000 credit card balance? Worse. You’re already getting crushed, and you must immediately cease making retirement account contributions (beyond getting the employer match in a retirement plan, as always), instead directing that money toward paying off your credit card as quickly as possible.
Not having invested a single dollar yet, just built your emergency fund to its initial $1,500 target, and have a $10,000 credit card balance? Worse still. As above, you’ve got to eliminate that debt as quickly as possible before you begin any investing (beyond getting the employer match in a retirement plan, as always).
In summary, what does all of this mean? It means we do whatever it takes to eliminate all high-interest debt as quickly as possible so that we can be in a position to benefit as much as possible from investing. Eliminating all high-interest debt and staying out of it is that important to successful investing, and it’s why we’ll tackle ways to eliminate high-interest debt next time.