Today’s year-end planning tip will cover Investing or Paying off debt.
This is not exclusively related to year-end planning, but is relevant for planning in a high interest rate environment and should be discussed with clients today who are faced with this dilemma.
Determining whether to use your excess cash flow or investment assets to pay off debt or to continue to contribute to your savings and remain invested can often be a matter of personal preference and there is no easy answer. While you may have the opportunity to earn greater returns from investments, many investors prefer the relief from eliminating the burden of debt from their lives.
While I can’t provide an easy solution to this what I will offer are some points to consider:
Higher rates and investment income: As inflation moderates, current yields available in fixed income investments may finally provide investors in this asset class with interest payments that make bonds more attractive. It’s not uncommon to get 5% or 6% on investment grade fixed income these days. This is very appealing for high quality bonds and should be considered UNLESS you have a large debt burden.
Not all debt is created equal: The most important factor in determining how to best advise a client is classifying the type of debt with which they are burdened. For example, credit card debt is the cancer of personal finance. The average credit card interest rate is nearly 23%, so this type of debt can very quickly grow out of control and become insurmountable. In such a situation, I would advise clients to sell their investments, even at a loss, in order to pay down their credit card debt in full.
There are other types of debt that, while still not great, are less bad. One example is a variable-rate loan. The solution in such a situation depends on many factors, including when the rate is scheduled to rise, the purpose of the loan, and the client’s projected cash flow to pay down this debt. For a borrower with an investment property whose mortgage is set to climb higher, I would evaluate the property’s monthly cash flows to determine if it is possible to keep the investment profitable for a few years until the market dynamics change or the market goes up in value. Running to sell an investment may or may not be optimal depending on the situation.
Then there are those clients with so-called good debt, who are temporarily having difficulty making their debt payments because business has slowed due to the economic environment. Take a homeowner who refinanced their mortgage in 2021 to a 15-year loan at a sub-3% interest rate. I would advise this client to continue to maintain their loan at a historically low interest rate and find other nondiscretionary expenses to cut, to avoid selling stocks, or other investments in order to pay down this debt.
Personal finance is PERSONAL: The goal of investing and financial planning is not about how to achieve the best return or the most optimal tax strategy. It’s really about being able to reach your goals, while allowing you to sleep at night. Striking this balance is different for everybody. It’s important to evaluate your personal goals, circumstances, and risk tolerance and put together a plan that makes sense for you and your family.