Fool.com: But What About Car and House Loans?[Fool on the Hill] May 10, 2000

FOOL ON THE HILL
An Investment Opinion

But What About Car and House Loans?

By Bill Mann (TMF Otter)
May 10, 2000

I received such a large response from my Fool on the Hill article from last Friday about credit card debt that I thought I'd follow up with some more detail in today's report.

Specifically, some people asked about a proper disposition toward auto loans, mortgages, property, school loans, high/low interest rate cards, tax-free/retirement accounts, and margin as it refers to investing. These items are all under the umbrella of "debt," but to my mind must be handled differently from one another in regard to investing activities.

Please keep in mind that these are my opinions on the subject, and I am by no means a debt counselor. I take a common sense approach to debt with an emphasis on lowering my risk profile on the debt side so that I may take higher levels of risk in investing. So to my mind those who maintain high levels of debt AND invest in very risky stocks are playing "chicken" with their financial future.

When I speak of the necessity for individuals to clear their books of debt before investing, I am largely speaking of consumer debt. To my mind, this includes credit cards and auto loans, but not student loans or home mortgages. The reason for this is not one of convenience. Rather, it lies in the nature of the asset backing this debt. Almost all consumer debt is taken in consideration of depreciating assets.

You buy groceries with your credit card, and you can rightly assume that you would not be able to resell them for as much money. There is not a huge market for "used groceries." In the same way, cars are depreciating assets. The older a car is, and the more usage it endures, the less value it has, unless of course it becomes a collectible, which would apply for less than 1% of all automobiles.

Now I'm a bit of a debt hawk where this goes, and admittedly so. My own rule on cars is simple -- I buy what I can afford, without financing. For this reason I drove a wonderful little 1979 Toyota Celica until the bolts fell out of it, and then bought a new car with cash that I had saved up for that purpose. By doing so, I eliminate both the pesky interest charges that increase the price paid for an asset that loses value, and I also force myself to select a car that remains within a reasonable price range.

If you choose to finance a car (or lease, which removes some of the objection of asset depreciation, but adds some other considerations), then more power to you. Further, there are some car loans available with rates below prime. If you have access to low-interest loans when purchasing a car, there is a very reasonable argument to going that route.

But what if you have no choice but to finance a car? Should you pay it off before you invest? My answer is yes. Here's why: Money that you are investing should be long-term funds anyway. If you are in a cash position that forces you to finance a car, dare I suggest that the money you would be investing is quite likely to be money you need in the near term.

Since even the best companies sometimes have short-term swoons in their prices, you could be creating a situation where you have a cash crunch and are forced to sell these securities at a very inopportune time. As such, someone who does not have the cash to afford a car is also quite unlikely to be in an optimal position to invest. If this is you, then pay down the car first and hone your investing skills using an imaginary portfolio instead.

As I pointed out last week, The Motley Fool has a dynamic credit card and debt area with all sorts of tools and advice to help you gain control of your finances. One of the questions I received had to do with moving debt from a high interest card to a lower one. In a word, absolutely. You should fight, scratch, and claw your way to the lowest interest rates possible. Pit card companies against one another. Make 'em work for your business. But low interest consumer debt and NO consumer debt are very different things. Personally, I like my money to work for me, and I'm not too excited to have to send out interest payments each month on debt.

Ah, but non-consumer debt is a very different thing. Non-consumer debt is, in my layman's nomenclature, any debt attached to appreciating assets. This relates to home mortgages, investment property, even student loans. In theory, and in most instances, the debt is being backed by an asset that is going to gain in value, such as your house, or, if you will, your brains. This type of debt is not necessary to alleviate before one begins to invest.

Still, you should not invest with resources that you may need in the short term to meet one of these obligations. Because even though these types of debt are additive, the obligation to pay them is still guaranteed. Banks are not very understanding toward people who pay late just because they lost money in the stock market. I'm not sure why this is, but believe me, they don't like it.

Fools have written a great deal about using margin in the past to juice up investment returns (for example, see this Fool on the Hill from last month). To review and encapsulate: don't use it. Margin, like credit cards, is a useful way to add short-term liquidity. But both have the opposite effect when used to excess. Ask people who were margined to the hilt this past March what happens when the assets securing that margin drop in value. The CliffsNotes version is that the dreaded margin call can force you to sell at the least opportune time -- when the prices for companies have dropped. Bad. Very Bad. Evil Stepmother bad.

Speaking of Evil Stepmothers, I was trying to remember the names of the Seven Dwarves the other day. Can anyone help? I remember six of them (Dopey, Doc, Torpid, Slimy, Webster, and Mike Lookinland), but I can't remember the last one.

And finally, several Fools asked me about paying down credit cards before one takes advantage of tax-deferred retirement accounts. You know what? I agree with the sentiment that one should always take full advantage of a 401(k) or other retirement plan. The reason being that, although there are many permutations on these plans, these investments are vested pre-tax, which means a benefit of as high as 40%+.

Unless your debt comes from "Sharks R Us," with interest rates that rhyme with "usury," you're actually doing yourself a favor to put money into your retirement account first. But with post-tax dollars, the averages say that you're better off to get out of consumer debt before you jump into investing.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards

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