In this newsletter, we are going to discuss debt. Now that interest rates are going up, the topic becomes very relevant.
Understanding and managing your debt is a critical part of the financial planning process. Debt is how much you owe and the payments you make on that debt are a constant drain on your finances. As a result, you might think it is best to pay off that debt. That is usually true but not always.
Different types of debt have different interest rates associated with them, think of it as the cost of holding that debt. You should only consider holding onto debt if you earn a higher rate of return AFTER TAX from your money than the interest rate on the debt. For example, if you have a debt that charges 3%, but you can earn 4%, then you can consider getting rid of that debt. But since you probably cannot deduct the interest and the income is taxable, the two rates are close to the same thing.
There are other factors to be looked at for most people. Paying off debt is a guaranteed boon to your finances. In the above situation paying off that debt is a guaranteed return of 3%. There is zero risk involved. That 4% return likely has some risk involved. To compensate you for taking that risk, you should be getting a return of 5 or 6%. In addition to the financial benefits of paying off debt, there is a psychological benefit as well. When Daniel and Yinan finished paying off the mortgage on their house, it took a tremendous amount of psychological pressure off them. Even though the interest payments were low, and Daniel could very likely get an investment return larger than that interest rate, the knowledge that they were debt free was very comforting. Eli has been very careful in his life to not accrue any debt for he also takes psychological comfort in being debt free. Ultimately the decision of how much debt to carry depends on you. Generally, the higher the risk the higher the potential return. However, the higher the risk, the higher the chance of potential disaster. How much risk can you take both financially and psychologically.
Our recommendation for most people is that some risk should be taken. We firmly believe in investing in stocks even though they are inherently riskier than things such treasury bonds. Balancing risk and safety are essential parts of the financial planning process.
If you do decide to pay off your debt, pay the debt with the highest interest rate first. When that’s done move to the next highest interest rate, pay it off and repeat that process. Do not pay off your rental property debt, until you have all other debts killed. Rental mortgages are deductible on your tax return.
If you have any questions about your investments, please call at any time. We sincerely hope you got value from this newsletter.
We appreciate your business and trust.
Thank-You
Dan and Eli
As we’re writing these to help our readers, we would be very appreciative of any input in regards to what we should write next. If you want us to write about a particular topic, please contact me. Please contact me if you would like to submit a post to our blog.
If anything that we mentioned above interests you, please consider downloading our free e-book. The book contains our thoughts on investment management and some information that we think everyone should know. You can also download it below.
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