StreetSmart Group, Accounting, Chartered Accountants, Business Advisors, Auckland, New Zealand

Is Debt Reduction A Smart Investment?

As chartered accountants we see a lot of people in a hurry to make their first million (or two). We enjoy and admire people with vision, passion, ambition, and big dreams. However, we sometimes wonder if the old saying “More Haste, Less Speed” is true… These people usually are immune to advice about debt reduction, whilst very open to ideas about fast tracking wealth creation. Are debt reduction and wealth creation separate? Or are they different sides to the same coin? Many baby boomers were brought up with Presbyterian work ethics and associated money values drummed into them… “a penny saved is a penny earned”; “look after the pennies and the pounds look after themselves”, and so on. They were also taught to minimise debt. So, was this smart investment advice? Firstly we need to understand the difference between “good” debt and “bad” debt (and “very bad” debt, but lets not go there!). “Good” debt is usually debt that is tax deductible (incurred to produce income) and/or incurred to invest in an asset that increases in value (a property, a home, a business, your education etc). “Bad” debt is debt that is not tax deductible and/or does not finance something that increases in value (eg consumption items such as holidays, cars, plasma TV’s etc). For those of you who really wanted to know… “very bad” debt is debt borrowed at higher rates of interest, usually at credit card/loan shark interest rates of 20% plus, to fund frivolous items that have no value (restaurant meals, “little luxuries”, addictions etc.) So should the average Joe Bloggs use spare cash to repay debt, or invest? The answer comes down to numbers. The advantage of repaying debt is that the return is certain and risk free. Let us explain… if you have a home mortgage at 8% and you are in the top personal tax bracket of 39% you know that by repaying your mortgage you earn the equivalent of a risk free 8% pa after tax return (or 13% pa before tax). On the other hand you would be better off investing that money elsewhere only if the investment was risk free and guaranteed to return more than 13% pa before tax. Unfortunately, there are not many of those investments around. Although property over the recent boom did perform brilliantly up until 2007 and generally exceeded this return, it was not risk free and not guaranteed. The other question people have difficulty with is deciding whether to go for interest only loans or principal and interest loans. Once again it comes down to opportunity cost. If you can invest the principal portion of the loan repayment elsewhere and earn an expected higher rate of return after tax then certainly go for an interest only loan. If you can’t, then principal and interest is usually a better choice. What if you have a number of different loans/debts – which should you pay off first? To make this decision you need to record all your loans/debts down on paper or spreadsheet, along with the total amounts owing and the interest rates. If some of the debt is tax deductible then adjust the interest rate on those debts to the net rate after tax (multiply the interest rate by 100 less the effective tax rate to reduce to the after tax rate of interest, eg 10% before tax of 33% means the real rate of interest after tax is 6.7%, that is 10% * {100-33}). Once you have all your loans recorded like this you can determine which loan to fast track – usually the loan with the highest rate of after tax interest or perhaps the smallest loan that can be repaid most quickly (great for your sense of achievement!) A word of warning here – many debt consolidators will recommend that you refinance all your smaller loans and debts into a larger mortgage secured over your home. This makes sense from the interest rate point of view (replacing credit card debt of 20% with home mortgage secured debt at say 7% can seem like a great idea). However, what people often don’t realise is that this can put you in a worse position because you have just swapped short-term debt for a 20-25 year mortgage. If you refinance a short term credit card debt by adding it to your 25 year mortgage you are likely to incur more interest in the long term, as you will still be repaying the original credit card debt in 25 years time! A much better idea is learning to budget and making the financial commitment to fast track your high after tax interest debts to get rid of them as quickly as possible. Instead of adding such debts to your 25 year home mortgage, you can add them to the mortgage as a revolving credit balance carrying slightly higher interest (say 9.5% rather than 7.5%) and then repaying the revolving credit amount as quickly as you can. Disciplined use of credit cards can be very beneficial as you can get up to 50 days free credit. If you pay the total amount owing by due date then you don’t incur any interest. If you’re financially disciplined use your credit cards to the max. If you’re not financially disciplined, cut up your credit cards and replace them with a debit card instead. Debit cards are similar to EFTPOS cards as you can only use them if there are funds in the bank to cover the purchase, but you can use them to purchase goods and services on line (just like using a credit card). While on the subject of revolving credit facilities, we think that every financially disciplined person should have one! In fact, we recommend our clients get the biggest ones they possibly can, especially if they don’t need it! Revolving credit facilities don’t cost you anything (other than a small set up fee) unless you use them. But once set up you effectively have this pool of money there available should an emergency crop up, or the deal of the decade comes your way. You can bid at property auctions knowing you have sufficient revolving credit available, if not to settle the deal then to pay a large enough deposit to enable you to get bank finance for the balance without any problems. However, as with credit cards revolving credit facilities need to be used carefully. They can be a trap for the financially undisciplined. Finally, we suggest that as you repay your mortgage arrange for the bank to add the principal paid to your revolving credit facility. In this way you maintain the total loan facility - the mortgage incurring interest reduces while the available revolving credit facility increases. It’s a sad fact that banks will usually lend you money when you don’t actually need it… but it can sometimes be really difficult to get finance when you do need it! An unused revolving credit facility can be a smart investment strategy.

As chartered accountants we see a lot of people in a hurry to make their first million (or two). We enjoy and admire people with vision, passion, ambition, and big dreams. However, we sometimes wonder if the old saying “More Haste, Less Speed” is true…

These people usually are immune to advice about debt reduction, whilst very open to ideas about fast tracking wealth creation. Are debt reduction and wealth creation separate? Or are they different sides to the same coin?

Many baby boomers were brought up with Presbyterian work ethics and associated money values drummed into them… “a penny saved is a penny earned”; “look after the pennies and the pounds look after themselves”, and so on. They were also taught to minimise debt. So, was this smart investment advice?

Firstly we need to understand the difference between “good” debt and “bad” debt (and “very bad” debt, but lets not go there!). “Good” debt is usually debt that is tax deductible (incurred to produce income) and/or incurred to invest in an asset that increases in value (a property, a home, a business, your education etc). “Bad” debt is debt that is not tax deductible and/or does not finance something that increases in value (eg consumption items such as holidays, cars, plasma TV’s etc).

For those of you who really wanted to know… “very bad” debt is debt borrowed at higher rates of interest, usually at credit card/loan shark interest rates of 20% plus, to fund frivolous items that have no value (restaurant meals, “little luxuries”, addictions etc.)

So should the average Joe Bloggs use spare cash to repay debt, or invest?

The answer comes down to numbers. The advantage of repaying debt is that the return is certain and risk free. Let us explain… if you have a home mortgage at 8% and you are in the top personal tax bracket of 39% you know that by repaying your mortgage you earn the equivalent of a risk free 8% pa after tax return (or 13% pa before tax). On the other hand you would be better off investing that money elsewhere only if the investment was risk free and guaranteed to return more than 13% pa before tax. Unfortunately, there are not many of those investments around. Although property over the recent boom did perform brilliantly up until 2007 and generally exceeded this return, it was not risk free and not guaranteed. The other question people have difficulty with is deciding whether to go for interest only loans or principal and interest loans. Once again it comes down to opportunity cost. If you can invest the principal portion of the loan repayment elsewhere and earn an expected higher rate of return after tax then certainly go for an interest only loan. If you can’t, then principal and interest is usually a better choice.

What if you have a number of different loans/debts – which should you pay off first? To make this decision you need to record all your loans/debts down on paper or spreadsheet, along with the total amounts owing and the interest rates. If some of the debt is tax deductible then adjust the interest rate on those debts to the net rate after tax (multiply the interest rate by 100 less the effective tax rate to reduce to the after tax rate of interest, eg 10% before tax of 33% means the real rate of interest after tax is 6.7%, that is 10% * {100-33}).

Once you have all your loans recorded like this you can determine which loan to fast track – usually the loan with the highest rate of after tax interest or perhaps the smallest loan that can be repaid most quickly (great for your sense of achievement!)

A word of warning here – many debt consolidators will recommend that you refinance all your smaller loans and debts into a larger mortgage secured over your home. This makes sense from the interest rate point of view (replacing credit card debt of 20% with home mortgage secured debt at say 7% can seem like a great idea).

However, what people often don’t realise is that this can put you in a worse position because you have just swapped short-term debt for a 20-25 year mortgage. If you refinance a short term credit card debt by adding it to your 25 year mortgage you are likely to incur more interest in the long term, as you will still be repaying the original credit card debt in 25 years time!

A much better idea is learning to budget and making the financial commitment to fast track your high after tax interest debts to get rid of them as quickly as possible. Instead of adding such debts to your 25 year home mortgage, you can add them to the mortgage as a revolving credit balance carrying slightly higher interest (say 9.5% rather than 7.5%) and then repaying the revolving credit amount as quickly as you can.

Disciplined use of credit cards can be very beneficial as you can get up to 50 days free credit. If you pay the total amount owing by due date then you don’t incur any interest. If you’re financially disciplined use your credit cards to the max. If you’re not financially disciplined, cut up your credit cards and replace them with a debit card instead. Debit cards are similar to EFTPOS cards as you can only use them if there are funds in the bank to cover the purchase, but you can use them to purchase goods and services on line (just like using a credit card).

While on the subject of revolving credit facilities, we think that every financially disciplined person should have one! In fact, we recommend our clients get the biggest ones they possibly can, especially if they don’t need it! Revolving credit facilities don’t cost you anything (other than a small set up fee) unless you use them. But once set up you effectively have this pool of money there available should an emergency crop up, or the deal of the decade comes your way. You can bid at property auctions knowing you have sufficient revolving credit available, if not to settle the deal then to pay a large enough deposit to enable you to get bank finance for the balance without any problems.

However, as with credit cards revolving credit facilities need to be used carefully. They can be a trap for the financially undisciplined.

Finally, we suggest that as you repay your mortgage arrange for the bank to add the principal paid to your revolving credit facility. In this way you maintain the total loan facility - the mortgage incurring interest reduces while the available revolving credit facility increases.

It’s a sad fact that banks will usually lend you money when you don’t actually need it… but it can sometimes be really difficult to get finance when you do need it! An unused revolving credit facility can be a smart investment strategy.

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