What Is Your Personal Cost of Debt?

Posted: Aug 07, 2020 1:01 PM
What Is Your Personal Cost of Debt?

Source: AP Photo/Keith Srakocic, File

There are a lot of different ways to measure how deeply you might be in debt. You could count up all the individual credit accounts you have, such as your mortgage, your student loans, your car loan, and all your credit cards. You can also add up all the liabilities you've racked up on each of these.

But that doesn't necessarily tell you how much your personal cost of debt is. For that, you'll need to know how much you've borrowed for each of your credit accounts and the interest rate you are paying to have already borrowed what you have.

With that information, you can find what your personal cost of having debt is, taking into account how it is weighted among your different credit accounts. We've built the following tool to do that math for up to as many as six different credit accounts you might have open. If you're accessing this article on a site that republishes our RSS news feed, please click through to our site to access a working version of the tool.

To use the interactive tools, click here.

In the tool above, if you have more debt accounts you would like to include in the calculation, take the results from the first six accounts, enter the total and weighted personal cost of debt interest rate in under "Credit Account #1", then continue to add the information for up to five more of your additional debt accounts. Repeat this process as necessary, until you're done. If it seems burdensome to do this, you may want to seriously consider reducing the number of credit accounts you have open.

Once you are done though, what can you do with this information?

Millionaire Mob describes it as one of the most important decision tools for making personal finance decisions you have available to you:

Personal cost of debt is so important. I cannot stress this enough. This is a line in the sand that helps you understand if you should pay down debt or invest. This is the best metric for debt prepayment....

For your personal cost of debt, you want to do anything in your ability to pay down the highest interest rate debt first. Lower your personal cost of debt to 4.5% or lower. At that point, you can invest everything you have.

The long-term average of the stock market is approximately 6-7% per year. With taxes, this is basically an annual return of about 4.5%. Thus, for every dollar you put into the stock market you should exceed your personal cost of debt. Keep in mind interest rates could increase or decrease, so this is somewhat relative.

If your final result for your personal cost of debt was above 4.5%, then taking steps to pay down your loans makes sense, where your biggest bang for the buck will come in paying down the credit that carries the highest interest rate.

We'll also note that Millionaire Mob is taking inflation into account in looking at the long term rate of return for an investment in the stock market. Over its history, the long term average rate of return for the S&P 500 is 9.4%, with the long term rate of inflation averaging about 3.3%, though the Federal Reserve has targeted a 2.0% inflation rate in recent years, which is how you get down to an investment return of 6% to 7% before you might pay taxes on your investment returns, which then drops to Millionaire Mob's threshold of 4.5% after taxes.

If you have the ability to invest with tax-free returns however, such as through a Roth IRA or a Roth 401(k), the weighted average personal cost of debt threshold for choosing between long term investing and paying down debt would rise to 6.0%, where you should choose to invest over paying down debt with any "extra" money you might have if your personal cost of debt is below that higher threshold.