Are there “best” ways for using debt?

| March 14, 2019 | 2 Comments

Mike Walden

by Dr. Mike Walden, NCSU Professor of Economics, March 13, 2019.

Two news items motivated me to write this week’s column about debt.   One is a debate in the North Carolina General Assembly over state funding for new educational facilities, such as school buildings.  The other is a new study on how households pay off debt, and whether they use economic logic.  There are some surprising results from the study.

There are two competing plans for state financing help with school buildings and related facilities.  One would have the state borrow a large amount of money, use the funds to construct the structures, and retire the debt over a long period of time – likely decades.

This is the standard approach to financing large public projects, including roads.  Businesses use the same technique, and even households follow this process when they purchase “big ticket” items like homes.

In fact, let me demonstrate the logic of the “borrow now, pay later” approach to financing with the example of buying a home. Say a couple wants to purchase a home for themselves and their two young children.  They have decided raising a family in a dwelling they own rather than rent would give them more privacy and control over their lives.   But with the average price of a home in North Carolina now almost $200,000, the couple doesn’t have the cash available to buy a house outright.

 If the couple could borrow the $200,000 with a home mortgage charging 4% interest and allowing repayment over 30 years, they could have the home now as long as they can afford a $955 monthly mortgage payment.   Borrowing now and paying later allows the couple to enjoy the home while paying for it.

 The same logic can be applied to public projects like roads and schools.  These projects last many decades and will be used by multiple generations of state residents.  Borrowing the money to construct the projects now allows current and future generations to both use the projects as well as pay for them.

The biggest downside to “borrow now, pay later” is the interest charges paid on the borrowed funds.  In the $200,000 mortgage example, over the course of 30 years not only will the $200,000 loan be repaid, but almost $144,000 in interest will also be paid. 

Avoiding borrowing and interest payments are the advantages of the second proposal for funding school infrastructure.   The “pay as you spend” plan would allocate money directly from the state budget for building schools and other educational structures.  No borrowing would be involved

On the surface, “pay as you spend” sounds more frugal and inexpensive.   After all, there are no interest charges, and the state presumably would only spend what it could afford. 

Still, there’s a downside to “pay as you spend,” and to illustrate it let’s return to the home purchase example.  Let’s say our couple can exactly afford the amount of the monthly mortgage payment – $955 – for shelter each month.  This equates to $11,460 for the year.  Using “pay as you spend,” the couple would initially only be able to afford a home worth $11,460.   Next year they could spend another $11,460 expanding the size of their home, and they could do this in each subsequent year.   But at this rate it would take the couple 17½ years to give them the equivalent of a $200,000 home.  

The bottom line is, borrowing allows homebuyers – as well as governments – to get more now, but at a higher long-run cost.  Therefore, one key question our legislators will have to address is, how fast do we need to build school buildings. Stated another way, what are the relative benefits and costs of taking longer or shorter periods of time to upgrade our state’s educational infrastructure?

Shifting gears to the second debt issue, a new study examined how households allocate payments across several debts they owe. For example, let’s say Mike has three debts: a $10,000 debt on which he pays 15% interest, a $30,000 debt charging a 10% interest rate, and a $50,000 debt carrying a 5% interest rate.

Economic logic says any extra money Mike has to pay down debt should be allocated to the $10,000 loan because it charges the highest interest rate.  Lowering this debt more rapidly will save Mike the most in interest charges.  Once this debt is gone, Mike should move on to paying down the $30,000 loan because it has the next highest interest rate.

A new study shows people don’t do this! With any extra money to reduce debts, people allocate most of it to the debt with the highest balance, not the highest interest rate.   They may think they’re saving themselves the most money doing this, but they aren’t.

So I’ve given you a “two-fer” in today’s column. First, you decide the best approach for the state to financially support educational infrastructure improvements. Second, also decide if you’ve followed the best logic for paying down on personal debts.   This is a lot on your plate!

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.

    

Category: NC SPIN Perspectives - Opinions from NC Leaders & Organizations

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  1. Norm Kelly says:

    Mike’s post makes sense. Sometimes using debt makes sense. Sometimes it does not.
    As for the example of debt & interest rates, I have my own method to pay off debt. This may or may not make the most economic sense, but it makes the best payoff plan, in my almost-never-humble mind.
    I didn’t look at the interest rate before deciding the order I’d pay off these 3 debts. I looked at the balance. If I pay off the $10,000 debt first by applying the maximum I can afford to the monthly payments, then I can move that money to the next highest balance. If the payment on the $10,000 is $200/month (i know, silly number, but go with it for a minute, please), and I make a $300 payment each month, I’m cutting the debt by an extra 50% each month. I make the minimum payments on the other 2 debts. Since the smallest debt gets paid off quicker, I then allocate that $300 per month to the next debt, $30,000. In addition to the amount owed each month on the $30,000, I now am able to put that other $300 per month toward that $30,000 debt. I’ve already proven I can make that $300 per month payment cuz I’ve done it already to get rid of the first debt. This will make that $30,000 disappear in record time, also saving gobs of interest; regardless of what the interest rate is.
    When that $30,000 is gone, I’ve proven I can make the $300/month payment, plus whatever the payment was on the $30,000 debt. Therefore, logic says I can put $300/month, plus the payment for $30K, towards the $50,000 debt, plus what the original payment was/is for the $50,000 debt.
    This might not make sense if the interest rates are taken into account, but it makes sense to get the debts paid off in the shortest period of time. Hopefully after paying off this amount of debt in the shortest time possible, I’ve learned my lesson and choose to pay cash for everything else. Only an emergency would force me to use debt. But, then again, I’ve proven I can live on my income minus the cost of all the debt, so smart planning would say that a large portion of that debt payment would now be put aside in a savings account for emergencies so I’d have to use as little debt as possible in the future.
    I know, this is personal finance and not major spending, it’s small spending. Financing a house or schools statewide is different. But buying smaller items, like cars or water heaters or heating/cooling units, get paid for in cash according to my scheme. Most of gov’t spending also comes under pay-as-you-go. The more money gov’t allocates to foolish spending, the less it has to use for pay-as-you-go small stuff. Spending foolishly on socialist programs, as democrats are wont to do, wastes today’s money so future money can’t be spent but debt must be used. Throwing money at incredibly rich businesses to move or expand in our state is a perfect example of admitting that taxes are too high and only a chosen few should benefit from reduced overhead. I know, all pols like to play games with other peoples money, like to be able to say their efforts made it possible for XYZ initiative, but the entire state is better off when taxes are set at the appropriate level to cover expenses without penalizing some of us for the benefit of a small group. There is a fine line between taxes/regulation that’s too high and too low. Playing favorites with peoples lives and livelihoods is wrong for any pol. Something democrats fail to understand as they continue to pick & choose winners & losers. (though in most cases the choices democrats make tend to favor the party more than anyone!)

  2. George Barr says:

    Finance 101: Match debt repayment period roughly to the life of the asset being purchased.

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