Rethink what debt costs you

Pick up any article about personal finance and you’ll see the same story: we’re all spending too much, saving too little and carrying too much debt.

While there’s power in numbers, this isn’t the best pack to run with.

Part of the reason we keep accumulating debt is simply the way we think — and don’t think — about taxes.

Changing perceptions

We refer to income, both employment and investment, in pretax terms. We say, “I make $75,000,” not, “I make $57,978 after tax.”

Makes sense. How many of us actually calculate after-tax income? Besides, $75,000 sounds better because it’s a higher number, and we all like knowing we make more—even if we keep less.

On the other hand, we look at expenses based on their pre-tax value, as in, “I paid $50 for that.”

If the expenses happen to be deductible or qualify for a tax credit, the average person usually knows it will actually cost them less than $50.

Now, let’s flip this on its head. What would you have to earn to pay that $50? The Ontario resident earning $75,000 has an average tax rate of 22.70% and would have to earn $64.68.

That’s kind of a depressing discovery, isn’t it? The point is, considering before—and after-tax amounts can help us allocate our money differently.

The true cost of debt

Interest rates are currently near all-time lows, which is great news for anyone with debt. But what’s the real cost of this debt?

The chart “Pretax carrying cost” (below) shows the pretax carrying cost of various interest rates across various average tax rates. We can see a few things from this chart:

People with lower average tax rates have pretax carrying costs similar to the after-tax rate (as you might expect)
The inverse is true for higher income earners. The pretax carrying cost of an 18% credit card is actually 25.71%. In dollar terms, in order to pay $18 of interest on a $100 balance, you would have to earn $25.71, a full 43% more. Even a 3% rate turns into 4.29%.

To higher-income earners, this revelation can be rather shocking.

The subsequent reaction is typically, “Oh well, what can I do? I have to pay tax.” While this is true, it provides us with a new frame of mind for allocating funds.

In order to make those decisions, however, we have to consider the marginal tax rate. Why? The cost of debt using marginal rates can be seen in the chart “Cost of debt with marginal rates.” Looks a lot uglier, doesn’t it?

The folly of emergency funds

Most of us try to keep a cash cushion — somewhere from a few thousand dollars, to as much as six months’ income. Usually these emergency funds sit in regular or high-interest savings accounts earning up to 2%.

Meanwhile, those of us carrying mortgages are paying at least 3% interest. On the surface, this looks like a 1% loss per year. But again, this compares before—and after-tax interest rates, which we’ve seen is like comparing apples to oranges.

Let’s say you’re in a 40% marginal tax bracket have $10,000 sitting in an emergency fund as well as a mortgage. Based on the above rates, let’s see what happens when we consider the after-tax implications:

After-tax rate of return from deposit: 1.2%
Interest paid on debt: 3%
Total Loss: 1.8%

Most people would say that 1.8% is a small price to pay for peace of mind. But let’s look at it on a pretax basis:

Pretax interest earned: 2%
Pretax interest cost: 5%
Total pretax loss: 3%

Now you must consider, “If there were a new high-interest savings account paying me 5% instead of 2%, would I move my money?” Who wouldn’t? So the choice is clear: you should pay down debt instead of holding a pile of cash for an emergency that may never come.

But what if an emergency should occur? This is where proper planning comes in.

I encourage everyone who uses emergency funds to pay down mortgages to take out a home equity line of credit to use in case of emergency. Sure, that means paying interest when an emergency happens. But in the meantime, you save interest. There are also more advanced mortgage solutions, like all-in-one line of credit mortgages, that can make this even easier to implement.

True, the mortgage is a cost, not a return. But return increases your disposable income, and so does not paying interest.

Compound these savings over time and you’ll see how fast you can reduce their debt. That simple $10,000 deposit could save as much as $10,699.07 in interest over the course of 25 years. That’s equivalent to 3% a year, or the same thing as earning 5% a year pretax in a 40% tax bracket.

Pretax carrying cost