Should you reduce debt or use surplus cash to build wealth? Negotiating with future-you

Welcome to Finance and Fury, “Say what Wednesday”

• Where we answer questions about the world of personal finance.
• This week, the question isn’t from a listener but a common one recently from people I have been meeting with.
• Best strategy for surplus cash: to reduce debt or use it to build wealth?

Why is it important to ask this first?

1. Finite resources – economic problem
   • Wants and Needs – We have a lot of them
     • Physical things
     • Experiences like travel or going out
   • Resources – A lot of things cost money – Which is typically more limited than our imagination
   • Balancing act – Use what you have to get where you want to be
2. Budget and Cashflow – What is left after everything is paid for?
   • Things that reduce your cashflow
     • Taxes – Decreases what you have left
     • Lifestyle costs
     • Debt – Mortgage

What is spent on each, versus what is important 

• Now versus future needs – Your now needs will seem more important

Uses of disposable income – A hard decision

1. Factors that should help to determine:
   • Stage of life and the timeline
   • Priority
2. The options of cashflow
   • Reduce debt – More defensive
   • Build wealth – More expansive

Breaking down the options for each

1. Types of debt
   • Bad – Something against a non-investment asset which doesn’t generate an income
   • Good – Is it against something increasing in value, and can I claim the expenses?
   • Yes to both = Good debt which is a form of building wealth
2. Build wealth – Investments
   • Monthly investments
   • Salary sacrifice – Super
   • Using leverage = More debt

What to focus your cash flow on

1. Goals
   • How long until debt has to be paid off
   • Savings
2. Good – Pay down in time to retire, but wait until the last minute to start
3. Bad – Pay down ASAP, but not at the expense of investments
4. Investment – What are the income needs in retirement?
   • Hard to work out: Rough guideline – Rule of 20:
     • $X amount of passive income multiplied by 20
     • Multiply this number by 1 plus the inflation rate to the power of the number of years until retirement
   • How long do you have? Great to start early.

Answering the question: Should I pay down debt or invest it?

• Ask yourself if it is debt or investment as the priority to reach your financial goals?
• Am I on track to retire with enough invested?
  • Yes – Means you have enough to cover what you will need
  • No – You may need to focus on investments more
    • Look at the timeframes you have to work within
  • Do you have bad debt? Yes, will it be paid off before retirement?
    • Do you need to pay this off quicker?
    • How much, and by when?
  • If it is good debt, will the investment be able to pay for itself before retirement?
    • Or, will the income be needed to provide a passive income? i.e. used to live
• Putting it all together: Rules of thumb. Remember, this is not advice, but just some guidelines:
  • Bad debt is always bad.
  • Good debt declines in value the closer you are to retirement.
  • But if used correctly, can decrease the time until retirement.

Example: Person with $520,000 mortgage, just bought first place so they have a 30 year time horizon

1. Long term rates of 7%, repayments of $3,462 p.m
2. Option 1: Pay $20,000 onto a loan, or invest the money – 30 years
   • Loan – rate of 7% long term rate and P&I, versus lower rate
     • 7%: 30 years would save you $123,301 in interest and 3 years – If you kept your repayments the same
     • 5%: 30 years would save you $63,787 in interest and same 3 years – If you kept your repayments the same
3. Option 2: Investment – Put $20,000 into portfolio, getting 8% p.a. for 30 years
   • 30 years would be around $186k to $200k invested.
   • Taxes on investment income – Return: 4% Income + 4% growth, income will be taxed.
     • Either fund through cash flow
     • Or use investment income to pay for
4. What’s even better? Pay down the loan and redraw the funds as separate investment loan.
   • Convert debt to good debt. – Debt recycling that we have covered
   • Have best of both situations – Have investment, and while paying interest it is deductible.
   • You would have the $200,000 in investments and pay the loan with $123,301 of deductible interest along the way. Depending on MTR: lowest marginal tax rate: $25,893 to $57,950 at the top.

Summary – Remember this isn’t advice, just things to think about:

1. Should you pay debt or invest your cash?
2. Long time – Invest but not at expense of Bad debt costing too much
3. Short time – Bad debt, then invest or pay down good debt, or both.