Are you paying too much?

I am excited to introduce my brother, Anthony Silva, as a guest writer for “My Two Cents.” Anthony has over 12 years of professional financial experience – working with institutional investors and various banks around the globe. Anthony brings his knowledge of global capital markets to "My Two Cents" readers. He is also an avid reader of financial history, personal finance and human behavior. He lives in the Washington, D.C. metro area with his wife, two daughters and their dog, Otis.

Anthony holds a BA degree in Economics from Bates College and an MBA from Georgetown's McDonough School of Business. He is a Certified Treasury Professional (CTP).

Anthony Silva

Are you paying more than the listed price for items? Sometimes that’s good.

If you don’t pay off your credit card balance every month, you are paying more than the listed price for items you purchased. The average U.S. household carries $15,762 in credit card debt1 at a 15% annual percentage rate2. These households are paying about $2,400 in interest per year. In other words, they are paying $2,400 above the price of items they purchased every year. Five years of this behavior and they have paid $12,000 extra – and will have paid even more if they let the interest compound. Financial advice for these folks is easy: pay off this debt ASAP. But paying off debts ASAP isn’t always the best advice.

Generally speaking, there is good debt and bad debt. Good debt has a really low rate and leads to an opportunity known as “positive carry” - borrowing at a low rate and investing at a higher rate.

For example, if you borrow money at 4% and buy an asset that yields 7%, you have 3% of positive carry.

Successful banks and corporations engage in positive carry to maximize profits. Also, some financially savvy folks do this to enhance wealth when they buy a house. The strategy has two other potential benefits – liquidity and diversification.

Here’s a hypothetical example of how it works:

You have $500,000 dollars. You can buy a house for $500,000 cash. Or, you can put down $100,000 and take out a 30-year mortgage at 4% on $400,000. You can now take that $400,000 and invest it elsewhere. If you earn above a 4% annual return on your investments over 30 years, you’re in a positive carry position.

In addition to the positive carry, you have two other benefits of liquidity and diversification. More liquidity because you don’t have the $400,000 tied up in a house that’s much harder to sell than a stock or bond fund, which you can do with the click of a button. More diversification because you can spread that $400,000 across many different types of investments rather than buy one house – rule of thumb: diversification helps to reduce risk.

Which situation looks better to you?

pie chart

So, certain types of debt can make sense depending on your specific situation. You just need to figure out if you have good debt or bad debt. First, look at the rate and balance on your debt. Then, figure out if it provides you the benefits of:

  • Positive carry
  • Liquidity
  • Diversification

If it does, then maybe you don’t pay it off ASAP.

1 https://www.nerdwallet.com/blog/credit-card-data/average-credit-card-debt-household/

2 http://www.creditcards.com/credit-card-news/interest-rate-report-100114-up-2121.php

The information provided is general and intended to inform and educate. It is not intended as an offering of any specific products or services, nor to be construed as specific investment, legal or tax advice.

Individual situations can vary, as such; this information should only be relied upon along with an individual assessment in light of your own specific situation.