Say What Wednesday

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.

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