How Much Should You Borrow?

MARK RIEPE: In the first act of Hamlet, Laertes is returning to school in France.¹ Before he leaves, his father, Polonius, shares some famous advice:

Neither a borrower nor a lender be

Shakespeare is usually spot on, but, in my opinion, this advice is impractical, and it always has been.

Borrowing and lending are so ubiquitous that formal debt agreements have been around for as long as humans have organized into something resembling civil society. Hammurabi's Code, which dates back to 1800 BCE in what is now Iran, has numerous laws that reference how agricultural loans are to be handled.² The Rosetta Stone discusses the cancellation of debts³ in Egypt during the time of the pharaohs, as does the book of Deuteronomy from the Bible.⁴

In today's world virtually everyone participates in the economy as either a borrower or a lender and most people are both. If you've ever put money in a bank, you're a lender. If you've ever used a credit card then you're a borrower.

Of course, not all debts are the same. Sometimes we borrow to purchase assets that depreciate quickly in value. We also purchase assets with borrowed money where the asset actually has a chance to increase in value.

At other times we make a decision to borrow because we value the good we're buying so much that we want to use it right away rather than waiting a long time to accrue enough money to pay for it in cash. Cars and houses are obvious examples.

However, like so many financial decisions there are cognitive and emotional biases that can lead to poor decisions, and today we'll talk about some of them from the standpoint of the borrower.

I'm Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab.

It's a show where we study the cognitive and emotional biases that can influence your financial decisions. And we offer strategies designed to help you mitigate those biases and improve your financial life.

Before we get to our guest, there is one bias and one heuristic I want to cover.

The bias is exponential growth bias. A common exhortation when it comes to investing is to take advantage of the miracle that is compound growth. The idea is that as your investment portfolio generates growth, you can reinvest your earnings. As you do that you generate future earnings not only from the original portfolio, but also from the reinvested earnings. If returns continue to be positive and you keep reinvesting, the amount of total growth for your portfolio accelerates.

It turns out that people tend to underestimate the power of this effect. In one experiment⁵ subjects were given a series of historical numbers that showed growth and then asked to predict what the number would be several years later if that rate of growth continued. Almost all the subjects underestimated the power of compound growth, and they did so by large amounts. In other words, the accumulated growth was more rapid than they estimated.

I'm bringing this up for two reasons. First of all, compound growth of this sort is great when you're an investor because you're benefiting from it in the form of a larger portfolio.

The second reason is that when you borrow money you're on the opposite side of the transaction. You're the one paying interest on the debt. And if the principal isn't getting paid down, then the total cost of the loan becomes ever larger.

If you're a borrower, you need to know how much interest you're paying. As my grandfather once told me: If you're going to borrow money for something, calculate how much interest you'll end up paying before the loan is paid off. Add the interest you'll pay to the purchase price. Then ask yourself whether the thing you're buying is really worth that much money.

Understanding the importance of compounding is one of the reasons financial literacy is so important. Studies show⁶ that people who don't grasp compounding tend to save less and borrow more, even when controlling for other differences in their financial situation.

On the borrowing side, they underestimate the total amount of interest they will eventually owe and not properly account for it when making financial-planning decisions. They borrow too much because they simply don't realize how much it's costing them.

The opposite appears to be true on the saving and investing side. The power of compound growth is underappreciated and leads to more spending right now.

The heuristic I mentioned is mental accounting. The term refers to the tendency to segment our decision making into smaller pieces or accounts. I'm going to call it a heuristic and not a bias because I think mental accounting can be a helpful decision-making aid. Segmenting our decisions can make it easier to wrap our minds around the complexity of the decisions we're facing.

The problem comes when we segment our decisions too much and fail to see the linkages between them. The classic example of this when it comes to borrowing is a situation where we're saving for a goal, but at the same time we're borrowing money and paying interest.

The problem is that money is fungible. By paying interest on a loan, you're adding to your expenses, which, in turn, make it more difficult to save for the goal in the first place.

If you've ever been saving for a vacation while at the same time paying interest on unpaid credit card balances, you're making this mistake.

Joining me now to discuss how these biases can affect your financial decisions is Carrie Schwab-Pomerantz. Carrie is a senior vice president at Schwab, and she is also the president of the Charles Schwab Foundation and a CERTIFIED FINANCIAL PLANNER™. She's devoted a considerable amount of energy to issues like financial literacy, and it's hard to say that you're financially literate if you don't really understand debt and borrowing. Would you agree with that, Carrie?

CARRIE SCHWAB-POMERANTZ: Absolutely. It is core to financial literacy and having a secure life.

MARK: Let's start talking about this kind of concept I've heard you talk about before of good debt and bad debt. What are some of the ways that debt can be used to your advantage, which I think is what good debt is all about? Is that right?

CARRIE: Yeah, let me just explain sort of the differences, or the way we see it. But first of all, even before getting into what is the difference between good and bad debt, too much debt of any debt is not good, because, obviously, it straps you and your lifestyle, and it doesn't really matter what it's going to lead into, that debt. But let me just share. So there is good debt, so think about a mortgage, a home mortgage, or a student loan would be considered good debt. Bad debt, you mentioned, credit cards or car loans would be considered a bad debt. Let me dig a little bit deeper why we distinguish between the two.

So a mortgage has, it's for a home. Now, admittedly, we've seen where homes don't appreciate at the same level that they maybe once did, but it is a place to live. And it's typically lower interest. So in a sense, you're investing in that home. You're buying something you otherwise could not do without a loan.

A student loan is similar. You definitely still don't want too much of you know, any loans, including student loans, but again, they're sort of a leverage. If you look at … the Census Bureau says that folks who have a college degree are going to earn twice as much over their lifetime than somebody who does not. So again, you're buying into something, or you're borrowing so that you could have a better life later, later down the road.

MARK: And going back to the bad debt concept, really, it comes down to if you're borrowing money for those day-to-day living expenses, that's a situation you would like to avoid. And that, typically, is where a lot of credit card debt comes into play, is that right?

CARRIE: Absolutely. And what happens is, I think, people, they run up their credit cards, it becomes a way to extend their income. A credit card is certainly useful for all of us. It's a great, you know, way to manage our money, you know, not to have cash all the time. It just simplifies our money-management process. So it's best, if you're going to use a credit card, to pay it off on a monthly basis. And Mark, you know this better than anybody, but because credit cards are non-deductible, the interest on it is non-deductible, you're paying, what? Fifteen percent interest. Just think if you could take that 15% and put it into your savings.

MARK: Carrie, one decision many people face is whether or not to pay off all their debts before retirement, essentially, retiring debt-free. Does that make sense to you?

CARRIE: Yeah, I think it's great when anybody who is entering their retirement is taking a hard look at their, I'll call it their balance sheet, you know, what they owe and what they own, and making sure that they're financially prepared. But in terms of specifically around debt, it gets back down to the question of good debt versus bad debt. Certainly, you don't want to go into retirement when you're on a fixed income with a lot of bad debt, so great for anybody to get that paid off. Home mortgages are a little bit different. Remember, they're the good debt. So what that gets down to is crunching the numbers, and whether you can afford to keep that mortgage or not, and then checking in with your emotions. You know, how do you feel about having debt when you're in retirement?

MARK: So let's break that down a little bit. What are some of the ways of evaluating that decision?

CARRIE: Right. So the first is to look at your anticipated income during retirement and seeing how, can you afford to pay that, make that monthly payment within the income that you're going to have? I mean, that's first and foremost. The other is if you're going to pay it off, you've got to have the assets, the investments or savings to pay it off, and so I say look at your balance sheet, how much money do you own or how much equity you have that you can sell and pay toward that house.

MARK: Yeah, it may not be possible for some people, or they would have to sell practically all their assets to make it happen, and in which case, that's probably not a good idea.

CARRIE: Not a good idea, because, again, we need to have some sort of emergency backup of money that we can easily access. And people don't really realize is that a house is illiquid, right? I mean, you can't sell it in three days or so forth. So you definitely don't want to put all your eggs in that home basket. And then, also, another thought for somebody who might have a little more wealth, where can you get the better investment return, from your house or from your other investments?

MARK: Carrie, you've often talked about how financial decisions are not always about just the dollars and cents. For example, it's hard to put a price tag on the peace of mind for being debt free. How do you factor that in?

CARRIE: Well, that's certainly an important factor to anybody's decision, but, you know, as a personal finance person, we like to think, use the head first, right? It's all a math game. Can you afford it or not? I think you have to think about the math, and then you have to think about the emotions.

MARK: You mentioned taxes a couple of times and tax deductibility. How does that fit into the mix?

CARRIE: When we take out a loan, a mortgage loan, the IRS allows us to deduct interest up to $750,000 of a loan. And so when you're paying, say, interest of, I'm just going to make this up, 4%, with the tax deductibility, you're probably really only paying about 3% because you are getting some money back. So that sort of makes it more enticing to borrow for a home than, say, borrow for something else, because of the tax deductibility.

MARK: What's a good way of determining when your level of debt is getting too high? Is there a … I don't know, a specific number or a specific formula that people can use to kind of evaluate where they stand?

CARRIE: So it's not cut in stone, and certainly for everybody, or each individual, it's different. But in the personal finance world, we have a rule of thumb called the 28/36 Rule. You only want the maximum of 28% of your pretax household income paid toward a home. So if I have, say I have $100,000 salary, then I only want about $28,000 going to a home. But here's another number, 36%. And what we're saying for the same thing is that you don't want more than 36% of your pretax household income to go to all debt. So that would include your mortgage, any type of credit card debt you're keeping, or auto loans, and so forth. So 36% would be the max that we should go for a total of debt.

MARK: And going back to that first 28% number you mentioned, when you say 28% going towards a home, you mean principal payments, interest payments …

CARRIE: And tax.

MARK: … property taxes…

CARRIE: Yes.

MARK: … insurance, if you're … if you're required to have mortgage insurance. And then 36%, that's all the home stuff, plus all the other forms of debt that you may have—credit cards, car payments, you know, other forms.

CARRIE: Any forms of debt. And so I do think that a lot of people don't have other debt, it's just mortgages is their primary debt, so maybe it could go up more than 28% if you don't have other forms of debt. And if you're in retirement, those still apply, they're good numbers, because it's, again, based on your projected retirement income, but perhaps you might want to be a little bit more conservative, because, again, you're on a fixed income and you have no other sources, new sources of money to come in.

MARK: But like all rules of thumb, though, at the end of the day, this is a starting point. Do the analysis, do your budget, see where you stand, and then evaluate about whether, you know, you're comfortable with that.

CARRIE: Yes, it's all about whether you feel comfortable or not.

MARK: As we're recording this, the Fed has dropped interest rates another 25 basis points. So let's talk for a second about refinancing of existing debt. How do you go about making that decision? What kind of questions should you be asking yourself to decide whether refinancing makes sense?

CARRIE: It's really a math game, in terms of refinancing. And you have to, first, ask yourself why are you refinancing? Most people do that because they want to reduce their monthly payments. And in the last 10 years, you know, we've seen interest rates just go down, and it's been a great opportunity for homeowners to reduce their monthly payment. Some people do it for other reasons. Maybe they want to reduce the length of their mortgage, which would make the payment higher. Some people are taking out equity for different reasons. Why are you doing it, and how long do you plan to be in your house, and then what is the equity in your house?

MARK: So let's look into a couple of those in more detail. How long will you be in your house—why does that matter?

CARRIE: When you refinance your loan you are going to pay what they call points or fees, and that can be anywhere from 3- to 6% to refinance. And so what you're looking for is an opportunity to break even, because you are going to have to pay that upfront, or you could have them embedded in your monthly payment. But the bottom line, this is money that you wouldn't have paid if you hadn't refinanced. So not only do you want the payment to be lower, but you want it to be, also, soon enough to cover or break even with the fees that you were charged. So you have to do the math a little bit to see when that breakeven will occur.

MARK: So the refinancing, let's just create a numerical example here. The refinancing might cost you $5,000 in fees, and if you're only going to be in the house for three more months, yeah, you may have saved a half-percent on your mortgage rate, but you're not going to make up that $5,000 in three months.

CARRIE: Exactly. You're not going to make it up. In fact, you paid more to refinance, not reduce your overall cost.

MARK: Earlier you spoke about the need to think about what you're going to do with the money you borrow because some uses of borrowed money make more sense than others. The examples you used about borrowing to buy a house that might appreciate in price, or investing in yourself so that you might earn more are a lot like borrowing to make an investment. Is that a good way of thinking about it?

CARRIE: Yeah, I think a lot of people don't really think of debt as an investment, when, in fact, it is. If you think about it, it's probably some of the more savvy people that use debt to build wealth. You know, going back to the home example, it allows you to get into a home for a lot less money than if you had to pay cash, with the opportunity for appreciation. The same with people who borrow for a business, right? You're hoping to grow it and multiply it and so forth. Student loans, I mentioned, it could double your earnings potential over a lifetime. So there's that appreciation. So yes, I do see it as an investment. While bad debt, like a credit card, it just straps you, it's like a noose. And if you're somebody who overuses it, and I've heard of people having $100,000 in credit card debt, and they're paying 15% on things that have already gone by the wayside, you know, whether it's clothing, or dinner out, or whatever it may be. So yes, good debt, to me, the potential, if you use it right and responsibly is a way to build wealth and financial security.

MARK: Thanks for being here, Carrie. A lot of great information, as always. Thanks a lot.

CARRIE: Mark, always love being with you.

MARK: In our discussion, Carrie made an important comment about crunching the numbers to make sure that you fully understand the costs of borrowing and whether it is sustainable for you given your financial situation.

"Crunching the numbers" is always important when it comes to your finances, and it's especially important when it comes to borrowing. Remember what I said in the introduction—people tend to underestimate the total cost of their loans due to the exponential growth bias.

But which numbers should you run? That seems like an odd question, but it's important. Most of the time the financial services industry runs on percentages.

Asset managers talk about rates of return that your account earned and expenses ratios on mutual funds. Meanwhile, banks talk about the interest they're offering on deposits or the interest they charge on loans.

All of these numbers are usually done on a percentage basis. That makes sense, because these are general numbers that are applicable in a wide variety of client situations.

However, there's evidence that some people make different decisions when percentages are converted to dollars—especially in the context of borrowing.

One lender⁷ allowed independent researchers to systematically alter the disclosures they made to potential borrowers and to track their behavior over time.

The results showed that borrowers were 6% less likely to borrow money from the lender when the disclosures were made in dollars and illustrated the cumulative effect of borrowing.

We wanted to talk about borrowing on this episode because financial wellness is about both sides of your personal balance sheet. In other words, you need a plan to be successful with your assets as well as your liabilities.

The plan for your liabilities starts with understanding the terms and conditions of your loan and especially the interest you're paying.

When you're thinking about the interest rate, be sure to take into account the tax consequences of the loan.

But don't make the mistake of just looking at your borrowing in isolation. Look at it in the context of your overall financial situation.

Maybe taking out a loan looks like a good deal, but is it really such a good deal given the other debt you're already managing?

If the debt load is manageable, consider how you plan to use the proceeds from the loan. Even if you can afford it, borrowing to spend money on current consumption or goods and services that depreciate rapidly should be avoided.

Debt's a big topic, and it's impossible to cover all the elements of the decision in a single episode.

The good news is that if you'd like to learn more about managing your own debt, there are dozens of useful articles and columns from Carrie Schwab-Pomerantz at schwab.com/AskCarrie.

As Carrie mentioned, because mortgages have certain tax advantages and property values can appreciate, we often classify mortgages as "good debt." You can learn more at schwab.com/mortgagerates.

Thanks for listening. If you're new to the show, you can go back and listen to previous episodes at schwab.com/financialdecoder

As always, let us know how we're doing by leaving a rating or review on Apple Podcasts or your favorite listening app. It would be much appreciated.

For important disclosures and a transcript, see the show notes and schwab.com/financialdecoder.

1 https://www.folgerdigitaltexts.org/html/Ham.html 

2 https://en.wikipedia.org/wiki/Code_of_Hammurabi

3 https://archive.org/stream/rosettastone00budguoft/rosettastone00budguoft_djvu.txt

4 https://www.kingjamesbibleonline.org/Deuteronomy-Chapter-15/

5 William A. Wagenaar and Sabato D. Sagaria, "Misperception of Exponential Growth," Perception & Psychophysics, 1975.

6 Victor Stango and Jonathan Zinman, "Exponential Growth Bias and Household Finance," Journal of Finance, December 2009.

7 Marianne Bertrand and Adair Morse, "Information Disclosure, Cognitive Bias, and Payday Borrowing," Journal of Finance, December 2011.