DEBT.
A “four letter word” when it comes to wealth generation right? I receive a lot of questions surrounding debt from my clients, and for good reason. Because it’s not always easy to answer.
So let’s discuss!
Is it okay to carry debt? If so, what kind and how much? How do I know when I should try to make my money earn for me or, instead, free me from financial obligations?
I get why this topic comes up so much. Within the constraints of this pandemic, debt management can be a particularly urgent consideration.
But even during normal life, you may be plagued by indecision at times. With a goal of financial independence, what is the most prudent and effective path to get there?
This topic can get muddy because both paying off debt and investing are smart strategies for building your net worth. They both play a role. The question is, really, what kind of role and under what conditions?
But first, a quick word on spending.
You can’t pay down debt or invest for your future if you are living beyond your means. Let me say that one more time.
You cannot pay down debt or invest for your future if you are living beyond your means. Period.
- Do you know how much money is coming into your household every month and how much is leaving?
- Are you experiencing any stress in your standard of living? If so, how do you respond to it?
- When a little extra cash comes your way, do you immediately splurge on a vacation?
Your attitude toward spending and saving is your first priority when entering the pay debt vs. invest debate. Take some time to think about your ongoing spending.
If spending is getting in the way of saving and investing, reset to a level in line with your income by finding cost-effective ways to do the things you enjoy in life.
Okay, let’s look at some considerations and priorities regarding debt.
1. Reduce bad debt immediately.
Not all debt is the same.
Mortgages, student loans, business loans and debt consolidation loans can be forms of debt that add value to your life by contributing to your future wealth or income.
On the other hand, credit card debt, car loan debt, personal loans, and lines of credit do not add value to your life.
In general, bad debt is a loan that pays for anything that decreases in value and lacks the potential to add to your net worth in the long run.
Paying for that fancy vacation with your line of credit is bad debt.
If you want to think in terms of numbers, bad debt is also high-interest debt. What qualifies as high interest? It depends on who you ask. It might be any debt at a higher interest rate than a mortgage or student loan. Or it might be a particular percentage, like 8% or higher.
There is no debate about credit card debt: pay it off every month (which gets us back to living within your means). Then work your way down.
What’s the next highest interest rate you’re paying? And the next? You might want to tackle moderate-interest debt as well. I would suggest any debt at 5% or higher requires attention.
Money going out of your pocket at those rates eats significantly into the earnings on your investments—or into your ability to invest at all.
2. Consider debt repayment as a guaranteed return.
How you answer the pay down debt vs. invest your money question will partly depend on your view of what debt is.
This is not just a savings or cashflow question—some people with solid savings and decent investments don’t think twice about carrying debt. They can “afford” it. They view it as a natural part of life.
But if you look at debt repayment as a guaranteed return, it can be hard to beat “investing” in it. Even if you invest your money aggressively in stocks or real estate, you can’t be guaranteed a return that matches or exceeds what you’re paying out on even a low-rate credit card of 9% to 13%.
With quite low interest rates, mortgages are less of a priority. Personal loans, however, might need your attention.
They offer a pretty good return on your paying them off.
3. Make sure you have an emergency fund.
How is this item about debt? Because it’s a preventative measure. You could pay off all your debt, have little cash in your savings, and find yourself back in the red in a heartbeat.
Never mind that we’re in the midst of a pandemic, which has put financial stress on many people. What if a tree falls on your roof? Your HVAC system draws its last breath and dies? Your business falters for a reason you cannot foresee? Car accident?
Things happen. Unexpected expenses crop up. Emergencies arrive. And it’s important to be prepared.
Look at the possibilities with open eyes and a rational mind. Assess the risks and set yourself up with the funds you need to weather those storms and prevent the future accumulation of debt.
Now, let’s turn our attention to investing. How should you assess your priorities?
1. Tax-deferred (mostly retirement) investments.
If you can minimize or defer tax while investing, take those options seriously.
Begin by being clear about your goals (do you have children to put through school? Grandchildren?), and then take advantage of existing rules and tax vehicles to make the most of your money.
Obvious options are a Registered Retirement Savings Plan (RRSP), a Registered Educational Savings Plan (RESP), and a Tax Free Savings Account (TFSA). If you own your own corporation, your Individual Pension Plan (IPP) is tax-deductible to the company. And of course, if you or your spouse have an employer-matching pension option, take full advantage of it.
You’ll see that aside from the RESP, everything else on this list is (or could be) dedicated to funding your retirement. Obviously, you can use a TFSA as you desire. But in my opinion, retirement investing is the priority.
If you can, max out all of your available retirement accounts—and earmark non-retirement investment accounts for your retirement, if possible.
2. Invest in assets with high expected returns.
We can debate what “high” means, but generally speaking, with a longer investment horizon, stocks and real estate generally deliver high returns.
I debated the “stocks vs. real estate” question in a recent blog. I see both as excellent investment vehicles.
You know by now that I invest in stocks based on the buy/sell indicators produced by models we have created and back tested over many years, such as the Richard Dri Canadian Dividend Model. Avoiding emotional decisions and instead following a rule-based investment strategy should be the cornerstone of your strategy.
When it comes to real estate, consider the data supplied by MLS listings: In Toronto, the average price of real estate properties has increased by 123% over the past ten years. That’s a tremendous return on investment (before subtracting carrying and ownership costs).
3. Balance and rebalance your portfolio.
I’m not suggesting that you only invest in assets with high expected returns. Your portfolio should contain a balance that works for you—say, an asset allocation of 60% equities and 40% fixed income, with a +/- 5% maximum range of fluctuation.
That means that if equities decline to 43% and bonds increase to 67%, you will sell 7% of the bonds and buy 7% of equities, thus returning to the preselected 60/40 mix.
You will need to carefully consider your portfolio balance, depending on your goals, timeline and personality. I add it to this list because it’s a consideration in the pay debt vs. invest decision. Because if you can invest—and I hope you can—the question of “in what?” becomes central.
So we reach the end, and I have not told you exactly what to do. So I will now!
If you have outstanding debt, I believe you should do both: pay down debt and invest. But to have a more precise strategy, you will need to start with a careful list of priorities.
Do you have an emergency fund? Are you carrying bad debt? Have you maximized tax-deferred retirement investments? And so on.
If you’re not sure how to make that list, give me a call. I’m happy to customize my recommendations to match your unique circumstances and goals.
Never Retire Profile
If you enjoy sports, you may have seen Sister Madonna Buder—also known as “The Iron Nun”—in a Nike commercial that aired during the 2016 Summer Olympics. In the ad, the 86-year-old (at the time) is first seen kneeling in church in her professional capacity as Sister before she hits the road, swims across a lake, and then jumps on her bike. Buder is the oldest woman ever, at the age of 82, to finish an Iron Man Triathlon. She only began training at the age of 48 and has completed over 325 triathlons since. Now 90 years old, Buder continues to practice as a member of the non-canonical Sisters for Christian Community, a contemporary religious order that is independent of the authority of the Roman Catholic Church, while pursuing her passion for sport. Once asked about the secret to her success, she replied, “I train religiously.”
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