The High Cost of Low-Interest Debt

Lately, I’ve seen many emails from readers asking me whether or not I think a particular debt is “okay” now that interest rates are so low.

It’s true – collateralized debt for people with good credit histories has a very low interest rate right now. You can get car loans and home loans for stupendously low rates, and it’s easy to understand why it’s attractive to people.

Right now, you can get a fifteen year mortgage for $200,000 at a 3.5% interest rate, giving you a monthly payment of $1,429.77. Just a few years ago, that same loan would have come with a 5.5% interest rate, giving you a monthly payment of $1,634.17. That’s $200 a month less than it was just a few years ago, and many, many thousands less in interest over the course of the loan.

Monthly payments on a big loan like that look a lot easier than they did a few years ago, so people who have stable credit are looking at those options and thinking about the housing and automobile upgrades they could make right now while the “iron is hot,” so to speak.

There’s one problem: it doesn’t matter how low the interest goes, it doesn’t take care of my number one concern when it comes to debt.

Let’s look at it this way. Let’s say you take out a $20,000 car loan to buy a new car. The interest rate is 3% over five years, so the monthly payments are $360. You can handle that, right? You’ve got a steady job that pays well and so on, and you’ve got to strike while the iron is hot, right?

You drive off the lot and your car immediately depreciates by about 40% or so. It’s now worth about $12,000 because it’s inherently a used car now.

A week later, you lose your job. You can’t afford that $360 car payment, but you’re stuck with it. (You’re also facing a higher auto insurance rate.) Even if you sell the car, you can’t recoup all of the money you’d need to pay off the loan.

Let’s look at another angle. You decide to go ahead and get that mortgage, but you know money is going to be tight for a while. Your monthly bills are adding up to a very large part of your income.

A month later, your car fails and you have a $1,500 repair bill. You know that the car needs replaced before something else goes wrong, but if you stack a car payment in with the other payments, you simply don’t have enough to make ends meet.

The real problem is cash flow.

Do you have enough cash on hand to pay all of your monthly bills and still save a bit of money? Are you in complete crisis mode if you lose your job – or your spouse does?

If either of those are true, you’re in a position of insufficient cash flow and taking on debt becomes a much, much riskier proposition. It becomes a bet that nothing will go wrong in your life, and that’s just not a safe bet to take.

My suggestion is to avoid debt, always. The only type of debt that’s worth taking on is student loan debt. Mortgage debt is tolerable if you’re buying a low-end first house. Other than that, if you don’t have the cash, you shouldn’t be buying it. You’re piling on personal risk. You’re ensuring that you don’t have the freedom to make lateral career moves. You’re praying that nothing goes wrong in your life.

If you get lucky, it might all work out, but you had to walk a stressful tight rope to get there. If you don’t get lucky, you lose everything and are back where you started, except with creditors after you and a poor credit rating.

Neither a “nicer house” nor a “nicer car” is worth it. Get what you can afford and save for the next purchase, when you perhaps can afford something nicer with more reliability.

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