Get out of Debt! Bad advice?
One of the most consistent answers to the question What should I do? that you will hear from Chris Martenson and many other experts concerned with this subject matter is "Get yourself out of debt! Pay it off as fast as you possibly can." While I mean no disrespect to Chris or the other experts who have offered this advice, the more I have pondered this, the more I come to the conclusion that this is really, really bad advice given current economic conditions. The purpose of this thread is to explain my rationale and solicit feedback and discussion. Someobdy is "missing something" here. Maybe it’s me and you folks can elighten me…
Before going on, let me emphasize that I am not suggesting you shouldn’t worry about being in debt. You should. But I want to consider the question of paying down debt voluntarily now in contrast to a specific alternative: saving aggressively so that you could pay all your debt down from savings in the future. The debt is definitely a scary problem for all the reasons Chris and others have described. But paying it off now makes absolutely no sense in my opinion. The one exception would be any high-interest rate debt such as credit cards that charge 20% APR and the like.
Let’s create a hypothetical example to evaluate the relative merits of different courses of action. Suppose that Joe & Mary owe $250k on their mortgage.. They are concerned that in the coming crisis this debt will be their undoing, and after watching the Crash Course they feel inclined to cut back on their expenditures (definitely a good idea) and use all available spare cash to aggressively pay down all their debt. They work out a plan to eventually get completely out of debt by aggressively over-paying their installments.
Steve & Susie are in exactly the same financial situation and share Joe & Mary’s concerns. Like the other couple, they cut back on expenditure as much as they possibly can. But instead, they decide to continue making regular payments on their debt, and open a new savings account where they are going to aggressively start saving. They figure they can always liquidate that account to pay off their debt any time they like, but they figure "cash is king", and prefer to hang onto all the dollars they can for now. Their goal is not to pay off the debt, but to build their savings account to the point that its value equals their debt, putting them in a position to pay themselves out of debt any time they like.
First, let’s understand the trade-offs and costs between the approaches. The argument against the Steve and Susie’s solution is that they will be getting next to zero interest from their new savings account, but will still continue paying higher interest on their existing loans. A true statement is that if no other variables change, it will take Steve & Sally more time than Joe & Mary to get to an equivalent debt-independent outcome. However, they will be holding onto the cash, and thus keep their options open to change the plan if the world around them changes. Once Joe & Mary’s excess payments are made (to reduce debt), they can’t get that money back from the bank. Steve and Susie are instead setting money aside to pay off the debt, but not acutally paying down the notes. In finance parlance, Steve and Susie are paying an optionality premium. That premium can be calculated by multiplying the difference between the interest rate paid on the new savings account and the outstanding loans by the balance of the new savings account. That amount is their annual optionality premium cost, and will start low and increase over time in proportion to the size of the savings account. What they get for this premium is the flexibility to spend the saved money on something other than debt repayment if their outlook changes.
I contend that Steve and Susie made the smarter choice, unless the interest rate delta is really high (at least 10% rate delta). Now let’s consider why.
One of the ideas already under consideration is the cramdown which means that exsisting mortgages would be re-written by the courts or legislature to have a lower principal balance. This is the free give-away to the irresponsible that has so many of us responsible types up in arms. But whether we like it or not, it’s under serious consideration. Suppose that both couples have managed to scrape together $125k. Joe and Mary used it to pay down their debt by 1/2. Steve and Susie kept the money in their savings account. Then a national cramdown provision is announced that both couples qualify for. It gives everybody a 40% cramdown. Joe & Mary had paid their mortgage down from $250k to $125k. After the cramdown their new mortgage balance is $75k. That feels much better than $250k for sure. But Steve & Susie are still holding the $250k mortgage. After the cramdown they owe $150k, but they have $125k saved up. They are $25k away from financial freedom, but Joe & Mary are still $75k in the hole.
Another entirely plausible scenario that I just saw proposed in a news article the other day: Your mortgage backs a bond that someone somewhere owns. They can only get about 20 cents on the dollar for it in this market, so they are stuck holding an asset (indirectly, your house) that they really don’t want. So they effectively reverse the securitization process, and send you a letter saying "Hey listen, if you can come up with 60% of what you owe on this mortgate and pay it all at once, we’ll take it and give you a receipt as paid in full". This is a different socio-political scenario, but the economics are the same as the previous example.
Another scenario is what I call "walkaway optionality". In the United States, all residential mortgages are, by law, non-recourse loans. That means that if Steve & Susie default, the bank can take the house, but they can’t touch that new savings account. If things really go to hell and both couples’ houses are only worth $100k each on the open market, Bob & Mary still owe $125k against that $100 asset, or $25k of negative equity. At first glance, Steve and Susie appear to be much deeper in the hole, with $150k of negative equity. But Steve and Susie can legally just walk away from that house and buy the one next door for $100k cash, and still have $25k leftover. They key point here is a lot of people seem to think that being "way underwater" (big negative equity) is a really risky situation for them personally. Wrong! It’s a really risky situation for the bank, not the borrower.
But these aren’t even the scenarios that I worry most about. What if this situation really goes down the tubes, to the point that there are widespread defaults across the nation. We’re already very close to that, and this next big wave of Alt-A rate resets could very well put us over the edge. In that situation, there would have to be some sort of stay on foreclosures until the situation could be sorted out. Joe and Mary will get one thing and one thing only out of those aggressive pay-downs: The right to honestly say "We were the responsible ones through this. We paid the bank back when nobody else did!". But everybody else who didn’t act responsibly got to keep their house too. Steve and Susie on the other hand have plenty of cash (or gold) on hand to deal with day to day life during what could actually be a sovereign reorganization of the nation. They are still poised to pay down that debt any time they want if the situation dictates.
An additional benefit of the Steve/Susie approach is that they have the option of holding some or all of the savings in the form of gold bullion instead of a savings account. In past years one would argue that the gold pays no interest, but neither do savings accounts (practically speaking) these days. Now imagine a really, really serious SHTF outcome where the financial system is in complete shutdown, there is chaos in the streets, the rule of law has given way to "street justice", and the country is in complete disarray. If Steve and Susie have 125oz of physical gold bullion, they can live on it for a very long time even if paper money becomes worthless, and they can use it to get themselves and their loved ones out of the country if it comes to that. On the other hand, Joe and Mary are dead broke, can’t buy food, and have only the satisfaction of being able to say "We were the responsible ones who paid off our debt". That and some of Steve & Susie’s gold will buy them a cup of coffee.
I can only think of two reasons that Joe & Mary’s approach (recommended by Chris and many other experts) would be better. The first is that if the financial system continues to basically function normally and we get through all this without much more economic turbulence, Joe & Mary didn’t pay the optionality premia whereas Steve and Susie did. But if you think the financial system is likely to just continue functioning normally you wouldn’t be reading this to start with. The second reason (and it’s a very real one) is that people in general are notoriously terrible at financial discipline. Steve and Susie’s plan won’t work if they become tempted by a growing savings balance to spend the money on something else. But if you can overcome the discipline issue, my contention is that paying down your existing low-interest rate debt now is a really, really bad idea. Have I missed something?
I don’t know if anything has been added to the Crash Course on this subject since I took it last summer, but I imagine there and elsewhere the injunction to get out of debt was not anticipating a deflation.
Under today’s circumstances, indeed, the best thing to do is buy useful assets, perhaps even going into debt to do so (if you can get a loan), with the dollar relatively strong and so many debtors having to dump assets for a song. Paying down debt right now beyond the minimum seems to be paying more than you need to. After all, when it was borrowed the dollar was probably worth less.
(Actually, not everyone is still giving the same get-out-of-debt advice these days. Mike Ruppert has always given that advice, but the last I read he was saying if he still had debt today he’d seriously consider defaulting on it. Then again, he’s a really hard-core doomer who thinks total system collapse is imminent.)
Great post, Erik. Very well-written and easy to process.
I also have kinda been coming to the same conclusions myself.
Ethically, the right thing to do is pay your bills in the end. Walking away from an underwater house while buying another house for its "real" value is pretty unethical – but if you consider that the whole mess we’re in is due to some very unethical, or at the very least, irresponsible, behavior of banks and institutions, one has to wonder if, at least in the economic world, ethics has been completely redefined.
I agree that having money, or gold, in some sort of savings gives you way more flexibility than having no savings but owning your house outright. I’d also be willing, as you mentioned, to pay a little for that increased flexibility.
Thank you, Erik, for this excellent analysis. I’ve been wondering the same thing. Another factor is that since the dollar is highly likely to be devalued, dollars paid on loans 5 years from now will be worth less than they are today. In the same way that governments inflate themselves out of debt, waiting for the dollar to be devalued, then paying down the debt is one way to meet one’s ethical obligation, while still defacto paying a more realistic price for one’s home. In the meantime, one can hold gold with the money saved, and sell it for an increased value as the mortgage payments become due. As you pointed out, one still retains optionality with this strategy. Having cash or gold reserves increases one’s ability to respond to changing conditions. I believe this will be key to surviving these tumultuous times.
Thanks for shining a light on this.
Great post and I couldn’t agree more with your observation of this situation. In fact, my wife and I have been employing the strategy of your hypothetical Steve & Susie with our student loans. Last year we opened a GoldMoney.com account to serve as our savings account (in addition to purchasing and holding bullion ourselves). Though we are sure to experience large fluctuations in the value of our savings account (as the price of gold fluctuates), I believe in the end that the account will preserve our purchasing power better than a typical savings account would. My strategy is a simple one. I see two likely options for government in dealing with this financial crisis. The first is to move the "toxic" private debt to the public sector, via bailouts, and pay it down with massive inflation. In that case, if gold holds its purchasing power relative to the inflated currency, our student loan debt would become relatively cheaper in the future, given that the nominal value of our debt would stay roughly the same but the value of the dollars that it is denominated in would drop. The second option for the government is to abolish the toxic debts and start over. In which case our country experiences some form of hyper-deflation and daily life becomes a whole different ball game. If that were to happen, I wouldn’t be worried about paying the student loans. I would be worried about physical survival. Having a "savings account of gold" in that situation might be the difference between life and death.
Having said all that, I do worry about an unforeseen bear market in gold, or Fed intervention in the gold markets, ruining our plans. Reading your post made me feel better about our decisions. Thanks for sharing.
Sorry, I didn’t see c1oudfire’s comment and mine is redundant. Besides, they said it much more eloquently than I did….Jeff
What if both couples lose their source of income? What do they both have govt. jobs or something?
Back to the experience of ancient China, one reason the Chinese culture pushes education isn’t for the potential opportunities out there in the entrepeneurial world, they push education because it helps to secure govt jobs, the SAFEST jobs during times of trouble.
That was exactly what we did in late 2004. We re_financed our house at 4.75% (interest) and pull all the equity invested in gold.
If there will be hyperinflation, it will wipe out the debt. If there will be a deflation as now, we are able to buy a complex of apartments (for future income) from the equity.(we didn’t buy yet since housing will go down more as long as there are more lay offs). If our house is "under water", I don’t ask, but order the bank to lower either the principle or interest like our neighbours did. (bail me out)
If the finance system collaps, we don’t need a house, we need gold or cash.
Will it collaps? Mr. Martinson said yes!!
Therfore, let’s not worry about the debt in your house, You need minimum of 3 month cash and food in hand first.
Teach me if I am wrong.
I have a feeling that Obama may be worse than Bush by creating a bigger government which supress the self healing function of the free market . None of what he did will help the fundamental of the economy.
This time, it seems, will be worse than the 1930’s.
If the finance system collaps, we don’t need a house, we need gold or cash.
If the financial system collapses, you will need food and drinking water, and a house might be more useful to you on the short run than gold.