I been thinking about debt lately. More so because I may go into debt if I choose to purchase a place of dwelling on my own but also that, since I have never been in debt, I am a bit deficient to think why people perform the way they do when they are in debt.
Not putting 100% effort into paying off debt
The majority of the folks do not build wealth the majority of the readers of this blog does. They tend to put their money in fixed deposits (which currently yields very very little).
I often reason that, the most theoretically rational action to take is to commit fully to paying down debt. The basic idea is that if its a 2.6% HDB loan, a 1.5% bank mortgage or a 24% annual credit card interest, paying off the debt fast is close to earning a 2.6%, 1.5% and 24% compounded returns.
The opportunity cost of not paying off the debt is to incur those kind of interest. This is straight forward because the alternative kind of saving or wealth building yields a very big step down.
Your mileage will vary if you are more savvy and can put your money in an endowment, a portfolio of unit trust or exchange traded funds or individual stocks. Then we have to weigh the overall returns over that X period of time, the piece of mind versus threading a debt tight rope for better returns.
In the majority of the cases, a full commitment to pay off debt when you realize that debt really gets you no where is the right thing to do. Yet I don’t see a lot of people having that vigour to commit a large part of their income to paying it down.
The main reason i felt is that, its difficult to frame your mind that you are earning a ‘return’ by paying off debt, even if your money sits idle in fixed deposit. And the debt repayment period can be a lengthy time even if you put in much effort say 5 to 7 years.
Doing a full commitment debt repayment requires discipline and willpower, which can be made easier if the debt repayment is automated, but at most time the person will likely be feeling depressed as a full commitment makes him or her missed out on much precious things. It can be rather dangerous as well if there is an emergency that comes a long, and that because of a full on commitment to pay off debt, the person doesn’t have any emergency funds saved up.
Depress and low morale gives a bigger opportunity for the person to fall off the debt repayment bandwagon. Since the main reason folks get into a bad debt situation is because of behavioural issues, all the more the ideal plan needs to factor in their tendency to do stupid things.
It is why a lot still commit to debt repayment but also build up savings. The savings portion is somewhat like a ‘reward’ that the person can see grow as time passes, so that they don’t feel like they are missing out on building something meaningful. Some feels better when they see their stocks and bonds grow in value over time while paying off debt.
In a way, they benefit from learning 2 wealth lessons over time, that not being tied to debt is a good idea and building wealth have its reward. As long as it gets the person to stay on track, is a massive upside compared to something theoretical yet likely to fail miserably in real life.
Debt as a pay cut
If we take the mental framing further, paying debt is also means you cannot spend that amount of money . When you are not spending that amount of money, it is as if you never received that amount of money in the first place. We can have a debate of what are the ‘assets’ that we are paying for, where some of them really have economic value down the road, but cash flow wise it does look like a pay cut.
When cash flow is limited, it also puts the person’s personal or family financial statement in a more risky situation. They will have less leeway when risk events such as a medical emergency, positive education opportunities comes along.
The best opportunity to pay it down is during performance bonus time, where the person or the family have a large inflow of money. Yet most will think more of enjoyment rather than de-risking their lives.
Folks spend their whole lives slowly paying off debt, first their poly loans, then their university loans, add on the mortgage loans and hopefully not a masters education loan along the way. This is where you have to be sure the kind of job you hold, whether its a bond or an equity. If you are holding on to a government sector job, then perhaps there are some ‘defensiveness’ to this stream of human capital income, if not, then temporary being unemployed can cause some very unpleasant situations.