The True Cost of Debt

There is more to consumer debt than meets the eye. For instance, interest is not tax deductible. Consumer debt differs from debt incurred to purchase investments. If you borrow to invest, the interest charges are tax deductible because the taxman anticipates that there will be future investment income that can be taxed.

However, for consumer spending, there is no tax break. If we borrow to purchase a car, we face costs over and above the quoted interest charge because, when we subsequently repay the loan, we have to use after-tax dollars. For example, if during the year you pay the bank interest charges of $500, your cost is not just that amount. You must earn $750 (before tax, assuming a 33% tax rate) to have $500 in your pocket to pay the loan interest. So your cost of borrowing is $750, not $500.

Types of Debt

Not all consumer debt is the same. Credit card debt and department store cards have significantly higher rates than those charged for bank consumer loans or for mortgages. To put these charges into a “true-cost” perspective, the following table shows what the “true” interest rate is for various loan interest charges. For this example, it is assumed a person’s tax rate is 33%; that is, in the middle-income range.

 

Quoted Loan Rate

True Cost
of Debt

Consumer Loan

8%

11.94%

Credit Card Loan

19%

28.36%

Retail Department Store

28%

41.79%

Strategy

In addressing debt, we need to identify our true costs and rank our debt for purposes of creating a debt-reduction strategy. Usually, our debt ranks from highest to lowest as follows:

  1. Retail department stores
  2. Credit cards
  3. Consumer loans
  4. Mortgages

If you have credit cards with different interest rates, pay off the highest interest rate card first. As the balance declines, keep the payments the same to accelerate the pay down. Once the first card is paid off, move on to the next highest rate one.

Example

To put another perspective on the “true” cost of debt, consider the individual who has $5,000 invested in a fixed income investment outside an RRSP. This person also has $5,000 of outstanding consumer debt on which he/she is paying 9% interest. Should the individual keep the investment or apply it against the loan?

  • Interest cost on the $5,000 loan is $450.
  • If this person is in a 40% tax bracket, he/she has to earn $750 of interest on the $5,000 investment, then pay: $750 x 0.40 = $300 in taxes on the $750 earned, to net $450.
  • Given today’s low interest rates, that will be hard to do.
  • To generate $450 after tax, the investment would have to earn a 15% return: $5,000 x 0.15 = $750 pre-tax.

Unless the investment is guaranteed to earn 15%, which is difficult to do, paying off the 9% loan is the better choice.

Conclusion

Debt reduction is one of the best investments we can make.