Eric's Loan Page

Debt in general is bad. But getting out of debt can be better than you might think.

I've recently been thinking about Ben Franklin's old adage ... "a penny saved is a penny earned." Actually, a penny saved is worth more than a penny earned. Let's say that you are in the 45% (Federal and State combined, plus FICA) tax bracket. In order to earn one cent after taxes, you'd have to earn ($.01/(1-.45)) = $.018. So actually, a penny saved is almost two pennies earned!!

By the same sort of logic, I extended the model to retiring debt. I used to think that, if you took out a loan and invested it at the same interest rate you were paying on the loan, you'd break even. But actually you wouldn't because you'd have to pay taxes on the income.

Therefore, by paying off a loan, you are effectively earning higher than the loan's interest rate in a 100% guaranteed investment! For example, if you pay off a loan of 10% (and were in the 45% tax bracket as described above), it is functionally equivalent to a totally guaranteed risk free investment at 18%! How about that -- a 100% guaranteed 18% return on your money!

If you are paying off a credit card that charges 20%, paying it back early is functionally equivalent to a totally risk-free investment of 36%! It is hard to beat that, as investments go.

This phenomenon is so powerful that I am trying to figure out creative ways of getting into debt so that I can get this guaranteed return while getting out of debt! So far I've struck out, though. The problem with getting into debt in the first place is that, in order to maximize the above idea, I'd want to "invest" the maximum possible as soon as possible for the guaranteed return -- I'd immediately pay off the whole loan and, in real terms, be back exactly where I started!


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This page last updated 01/03/02

© 1998, 1999, 2000, 2001, and 2002 Eric E. Haas

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