Debt
To be (in debt), or not to be? That is the question…
Over the past 20 years, a common question I’ve been asked by clients and prospective clients alike is whether to use a windfall – such as an inheritance or a bonus – to pay down debt or to instead invest the money. Arriving at the correct answer is not that simple; it depends on your own unique financial situation, as well as your personal feelings about debt and the risks that walk hand in hand with having to make the monthly payments on time, every time, without fail.
So many people have high interest (10%+) credit card balances. Life sometimes happens, right? Probably a good idea to use that newfound cash to pay it off. ASAP. It is generally advisable to start with the most expensive debt first, the debt with the highest interest rate.
But what about a car loan or a mortgage, which often have much lower borrowing costs than a credit card? In a vacuum, if the expected after-tax return on the investment exceeds the after-tax cost of borrowing, then investing – instead of paying down debt – will grow your wealth. The problem with this logic is that investments having higher anticipated returns than the cost of debt are rarely guaranteed, and the returns are often inconsistent. But for those who are more comfortable with taking on investment risk, and who have a long-term horizon (10+ years, for example), then this approach is worth considering.
Many wealthy people embrace debt in precisely this manner to maintain or enhance their lifestyle. A July 24th headline in the Wall Street Journal proclaimed that “Rich Americans keep Borrowing, Defying Economic Gloom.” The article went on to say that many investors were borrowing against their investment portfolios to pay their 2021 tax bills. This type of borrowing is commonly known as a securities-based loan, or a margin loan.
I sure hope those investors understood – before they borrowed - that the interest rates of those loans are usually tied to short-term interest rates, which have been rising sharply this year as the Fed tries to combat inflation. Simultaneously, the stocks and bonds – which serve as the collateral for those loans - are down significantly thus far in 2022. For those who “maxed out” borrowing, maintenance or margin calls may already have occurred, where the lender (their brokerage firm) can force the sale of securities to pay down the loan, potentially resulting in tax costs and a permanent loss in portfolio values. Borrowing against investments is not for the faint of heart!
When it comes to debt, perhaps the most important question to ask is whether you really need it in the first place. Do the benefits of adding to your obligations outweigh the financial and emotional costs involved? Good financial fitness requires a sober assessment of those very real consequences. There should always be a path to repaying it, as well as a Plan B and a Plan C for when your assumptions about your future ability to service it don’t work out as planned.
If you have questions about debt – whether it is debt that you already have, or debt that you are considering taking on to buy a car, a home, or an education – feel free to contact me at stu@bendwealth.com.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Holding investments for the long term does not ensure a profitable outcome. Future investment performance cannot be guaranteed and investment yields will fluctuate with market conditions.
