You Decide: Are there best ways for using debt?
By Dr. Mike Walden
Two news items motivated me to write this week’s column about debt. One is a debate in the North Carolina General Assembly over state funding for new educational facilities, such as school buildings. The other is a new study on how households pay off debt, and whether they use economic logic. There are some surprising results from the study.
There are two competing plans for state financing help with school buildings and related facilities. One would have the state borrow a large amount of money, use the funds to construct the structures and retire the debt over a long period of time – likely decades.
This is the standard approach to financing large public projects, including roads. Businesses use the same technique, and even households follow this process when they purchase “big ticket” items like homes.
In fact, let me demonstrate the logic of the “borrow now, pay later” approach to financing with the example of buying a home. Say a couple wants to purchase a home for themselves and their two young children. They have decided that raising a family in a dwelling they own rather than rent would give them more privacy and control over their lives. With the average price of a home in North Carolina now almost $200,000, the couple doesn’t have the cash available to buy a house outright.
If the couple could borrow the $200,000 with a home mortgage charging four percent interest and allowing repayment over 30 years, they could have the home now as long as they can afford a $955 monthly mortgage payment. Borrowing now and paying later allows the couple to enjoy the home while paying for it.
The same logic can be applied to public projects like roads and schools. These projects last many decades and will be used by multiple generations of state residents. Borrowing the money to construct the projects now allows current and future generations to both use the projects as well as pay for them.
The biggest downside to “borrow now, pay later” is the interest charges paid on the borrowed funds. In the $200,000 mortgage example, over the course of 30 years not only will the $200,000 loan be repaid, but almost $144,000 in interest will also be paid.
Avoiding borrowing and interest payments are the advantages of the second proposal for funding school infrastructure. The “pay as you spend” plan would allocate money directly from the state budget for building schools and other educational structures. No borrowing would be involved.
On the surface, “pay as you spend” sounds more frugal and inexpensive. After all, there are no interest charges, and the state presumably would only spend what it could afford.
Still, there’s a downside to “pay as you spend,” and to illustrate it, let’s return to the home purchase example. Let’s say our couple can exactly afford the amount of the monthly mortgage payment – $955 – for shelter each month. This equates to $11,460 for the year. Using “pay as you spend,” the couple would initially only be able to afford a home worth $11,460. Next year they could spend another $11,460 expanding the size of their home, and they could do this in each subsequent year. At this rate it would take the couple 17 and a half years to give them the equivalent of a $200,000 home.
The bottom line is, borrowing allows homebuyers – as well as governments – to get more now, but at a higher long-run cost. Therefore, one key question our legislators will have to address is, how fast do we need to build school buildings? Stated another way, what are the relative benefits and costs of taking longer or shorter periods of time to upgrade our state’s educational infrastructure?
Shifting gears to the second debt issue, a new study examined how households allocate payments across several debts they owe. For example, let’s say Mike has three debts: a $10,000 debt on which he pays 15 percent interest, a $30,000 debt charging a 10 percent interest rate, and a $50,000 debt carrying a five percent interest rate.
Economic logic says any extra money Mike has to pay down debt should be allocated to the $10,000 loan because it charges the highest interest rate. Lowering this debt more rapidly will save Mike the most in interest charges. Once this debt is gone, Mike should move on to paying down the $30,000 loan because it has the next highest interest rate.
A new study shows people don’t do this! With any extra money to reduce debts, people allocate most of it to the debt with the highest balance, not the highest interest rate. They may think they’re saving themselves the most money doing this, but they aren’t.
So I’ve given you a “two-fer” in today’s column. First, you decide the best approach for the state to financially support educational infrastructure improvements. Second, also decide if you’ve followed the best logic for paying down on personal debts. This is a lot on your plate!
Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook and public policy.