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.
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.