With interest rates having risen at their fastest pace in a generation the subject of paying off debt or whether it even makes sense to take it on is becoming more pronounced.
I wanted to share some thoughts around debt and how it may fit into your financial plan.
Debt Brings Your Buying Power Forward. The trade off of taking on debt is the cost of interest. The benefit is that you are able to borrow from your future self’s income. Put this way, to me, it sounds terrifying like you are indenturing yourself. But, taking on debt can often lead to positive outcomes. Imagine that you weren’t able to secure a mortgage for your first home and needed to save every dollar for the purchase. You’d probably still be saving; and renting. Or, imagine if you weren’t able to get a student loan for your post-secondary degree. Would you have the job and income that you have today?
Good vs. Bad. We can separate debt as either good or “productive” and bad as in “consumption-based.” Productive debt like mortgages, student loans or business loans all have something backing it and strives to outpace the cost of interest over time. On the other hand, consumption-based debt like expenditures on vacations, cars, furniture – are items and experiences that evaporate economically. Philosophically, productive debt is a bet on yourself and the future, whereas consumption-based debt satisfies your current desires.
Retirement & Debt. A 2018 SunLife study found that 20% of all retirees were carrying a mortgage balance. While there are certainly exceptions, this is not the preferred state. We want all debts cleared before you switch from earning employment income to generating retirement income. The logic is, yes, financial: you don’t want to be exposed to changes in interest rates or new debt requirements from the lender when you are entering retirement. More importantly is the emotional side when switching from the savings mindset to the withdrawal mindset. This is already a challenging phase to wrap your head around and adding on a layer of debt can only intensify the situation. Bottom line – make sure to align your payments to have your debts paid off at retirement – better yet 5 or more years before retirement for ‘just in case’ scenarios.
What About Prepaying Debt? If you had a handful of extra money should you pay down your debt faster? The answer is yes, maybe and potentially no. Yes – absolutely because we want it gone before retirement and maybe if the debt’s interest rate is higher than what you could otherwise earn. Let’s use some extreme examples to illustrate the point. If you had an outstanding balance on your credit card with an interest rate of 24% while the savings rate was 5% it is a no brainer to pay off the Visa. Now suppose, you had a mortgage rate of 1.4% and the savings rate was 5% it would not make sense to pay off the mortgage. That being said, in this case you might set aside the money, earn 5% and pay down the mortgage at renewal when rates may be higher. Now, these are simple examples. In the reality, the comparison should always be done using an after-tax tax point of view. This is the actual cost to you. And, the after-tax cost of the interest may be lower than you think or the after-tax interest that you are earning may be lower than you think.
Flexibility Is Worth a Lot. In most cases, when you pay down debt you lose access to those funds. You lose access to the flexibility that those funds bring. You never know when life may throw you a financial curve ball whether it be a special assessment at your condo, the need for a new car or unforeseen water damage to the basement. Even if the numbers point you in the direction of paying down debt you may still want to hold on to your extra cash. This is why companies, like Apple, issue large amounts of bonds despite having billions in cash.
Never Underestimate the Feeling of Being Debt Free. You could conduct dozens of analysis which could all tell you to maintain a debt load because it is in your financial favour. Still, nothing is more freeing that being debt free. I’ve seen it time and time again. Ask someone who has paid off their mortgage. They can most likely remember the time and place of their final payment.
Debt is not a four-letter word in all scenarios. It is something that should be used with thoughtfulness and stress-tested against unpleasant scenarios. If you have any thoughts or questions – please give me a call.
The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. This material is provided for general information and the opinions expressed and information provided herein are subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on the information presented, please seek professional financial advice based on your personal circumstances. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.
