WACC – Or Why Credit Card Debt is No Big Deal

by JT McGee

High-interest debt has long been considered a financial no-no – a death knell to personal balance sheets.

But what if high interest debt isn’t as bad as it seems? What if we could reverse engineer the careful thought of Dave Ramsey to come to such a conclusions?

Weighted Average Cost of Capital

In institutional finance, the weighted average cost of capital is a key part of the investment process. The weighted average cost of capital is comprised of debt and equity capital, weighted based on the amount of debt or equity making up a business at differing rates of return.

Long-story short: a business funded 50-50 with equity and debt where equity investors want a 10% return and debt investors want a 6% return would have a weighted-average cost of capital of 8%. The equation is simple: (10%*.5)+(6%*.5) = 8%.

We can calculate a weighted-average cost of capital for an individual, as well. If you have $2000 in credit card debt at 20%, $8,000 in auto debt at 5%, $20,000 in student loan debt at 4%, and $170,000 of mortgage debt at 3.5%, you have a weighted average cost of capital of 3.775%. The total cost of all your debt is 3.775%, even though some of your debt costs 20% while another part costs 3.5%.

As the largest debt is also the lowest interest debt, your total cost of debt is tiny!

The weighted average cost of capital calculation is the basis behind my post about financing depreciating assets. Just because you forego direct financing on a purchase does not mean the purchase is debt-free. The opportunity cost is paying down debt, which has to be balanced with your weighted average cost of capital. Thus, so long as you have debt, everything you purchase is, in fact, financed.

Dave Ramsey’s Place

Dave Ramsey has long been an advocate of the debt snowball method, which says you should pay off your debts in order from lowest balance to highest balance. Some (like me) would criticize him for failing to account for interest rates. In an ideal world, one should pay the highest interest balance first.

Luckily, interest and balances have a strong inverse relationship. The economics of lending require a lender to charge high interest on small loans, and low interest on large loans. Thus, in most cases, Dave Ramsey followers do actually pay off high interest balances first. At the worst, Dave Ramsey followers pay a few hundred dollars more in interest that they might not pay had they taken the time to evaluate the rate of interest on their debt.

Dave Ramsey is smarter than he leads on. He knows that in the aggregate, people who pay off smaller balances realize better outcomes. It doesn’t make his suggestions mathematically correct, just simplified, easier to digest, and more marketable to a wider collection of Americans burdened with debt servicing costs – which makes him a wealthier, more influential person.

He’s a smart salesman, basically.

Anyway…

The point is high interest debts of any type are not necessarily bad. The burden is not really about interest. Not at all – notice how in the above calculation a high interest credit card debt has limited impact on the total cost of an individual’s personal finances.

The real limiting factor is usually income – the spread between your monthly payments and cash flows to you is what makes people freak out. There are plenty of people with HUGE debts who will never feel pinched, and never seek out financial advice, because they can still afford to pay the bills each month.

As income is the limiting factor, small balances like a credit card or payday loan from a company like paydayloansresource.org are more costly on a month to month basis, even if these sources of financing do not greatly affect one’s average cost of capital. This is due to the amortization schedule. A credit card with a $2000 balance and $50 minimum payment amortizes in 5.5 years. The minimum monthly payment is equal to 2.5% of the principal balance. Compare this to a mortgage, where the monthly payment is equal to less than one-half of one percent of the total balance.

It’s all about cash flow. It really is. If you do a WACC analysis on your personal debts, you’ll see that your actual interest expense is relatively small (especially if you have large, low-interest balances.) However, the monthly payments on small debts are the most restrictive to your income and outgo each month, and therefore the largest single source of frustration.

{ 10 comments… read them below or add one }

Jonathan May 8, 2012 at 12:55

Perhaps not a big deal within reasonable limits, but that doesn’t mean it’s not wasteful. If you carry $5k of credit card debt at 20% interest that means you’re paying $1,000 extra a year in CC interest. For comparison, on a $400k mortgage at 5% you’re spending $20,000 a year in interest. However, to save $1,000 you can either pay $5,000 to eliminate the CC debt or you can pay $20,000 to reduce the mortgage principal. Further, once you pay of the CC debt you reduce your monthly minimum debt payments whereas paying down $20k on the mortgage does nothing to affect your monthly payments.

Whether you’ve got the cash flow to comfortably afford the payments or not, there’s rarely a good reason not to pay off 20% debt as quickly as possible.

Reply

JT May 8, 2012 at 13:00

I agree with you that it makes little sense to keep debt at a 20% interest rate. This article is really just commentary – it isn’t the high-interest rates that make people “feel” broke, but the unfavorable short-term amortization of high-interest debt that crushes people.

I would imagine that most people would go broke if their mortgage amortization were reduced to 5 years from 15 or 30, even if the interest rate is pushed to zero.

Reply

Dr Dean May 8, 2012 at 13:07

JT, good analysis. My debt would make most people run for the hills, screaming for their Momma, but I just rock along cause my income covers it easily along with allowing me to put money away.

That being said, I’m paying it off as fast as reasonably possible as it does limit my flexibility.

Your reply to Jonathan was excellent. And Dave R is a wonderful salesman!

Reply

JT McGee May 8, 2012 at 13:14

That’s probably the reality for new people coming into medicine today, isn’t it? Maybe the debt is from a different source in your case, but anyway, yeah – totally nice to have some excess over and beyond the money going out.

Slightly tangential – but I wish the indebtedness weren’t a reality with medicine. As a medical consumer, it’d be nice to have more doctors running around, heh.

Reply

Dr Dean May 8, 2012 at 14:03

Yea, I paid off my 6 grand in medical school debt years ago. The debt today is from my Florida beach real estate venture…Maybe if we don’t have any hurricanes over the next decade it will begin to increase in value….When you are wealthy, don’t buy a lot for your second home in Florida without talking to me first!

Reply

JT McGee May 12, 2012 at 11:23

Hey, you never know. Florida could be super hot in the future! I’ll take your experience to heart, though. Trust me, I won’t be chasing beachfront real estate any time soon. And if I do, it’ll be purely consumption, not an investment. 😀

Reply

PK May 8, 2012 at 23:58

It certainly helps that for most people, present company included, their largest debt is the mortgage on their primary residence – that WACCs the rest of my debt (what debt?) right off the map (and tax deduction)!

Reply

JT McGee May 12, 2012 at 11:24

Bingo! Those small debts may add up due to the amortization period, but it’s not the interest that kills the margin of safety between earned income and cash out-go.

Isn’t that deduction great? Do you get a state deduction too?

Reply

101 Centavos May 13, 2012 at 17:56

Good post, JT.
Still a good policy to not be in debt for personal consumption.
As for leveraging productive capital investments, that’s a different story.

Reply

tom buck June 15, 2012 at 06:30

good argument to back up the rather simple observation that there is no hard or fast rule, you can’t say high interest debt is bad or that low interest debit is good. It is completely dependant on a given situation. Any debt is fine if you can afford it, similarly any debt can be bad if you can’t afford it. That said it seems in any given circumstance you should always look to make use of the cheapest debt you can find. You mention payday loans, which get a bad press, but payday loans are a specific tool for a specific circumstance. They offer relatively expensive cash for the convenience of getting it quickly and without too many questions.
If you have access to cheaper borrowing in any given situation use that.

Reply

Leave a Comment

*

Previous post:

Next post: