Clients frequently ask if their debt should be paid down. Generally, we recommend avoiding debt other than a reasonable mortgage, especially as retirement approaches. In some cases, however, debt can be innocuous or even helpful. This chart summarizes the logical process for deciding to pay off debt. The steps are described below

## Cash Flow Risk

Carrying debt introduces cash flow risk. Think of expenses as either critical or discretionary. A critical expense, such as a debt payment, is one for which there are dire consequences if the expense cannot be paid.

A reduction of investment income for retirees or a loss of a job for workers puts their income in jeopardy. If the income falls too low, their critical expenses could go unpaid. Some people with highly reliable income, such as from Social Security or pensions, have less cash flow risk. If that reliable income covers all critical expenses, it is unlikely they will endure dire consequences from their critical expenses, including debts.

However, if the reliable income is insufficient to cover all critical expenses, then those expenses must be paid from potentially unreliable investments. Using unreliable investments to pay critical expenses could expose the investor to dire consequences if the markets underperform. Hence, paying down debt may reduce critical expenses below the reliable income levels.

## Low Debt Interest and Long Terms

Long-term loans with low interest rates, such as mortgages, are more tolerable.

The term is important because long-term anticipated returns on investments are higher than short-term anticipated returns. The investments can be more aggressive for long-term investments because the additional time mitigates the statistical volatility. Furthermore, the returns from long-term investments are more likely to be closer to historical average returns.

Similarly, an interest rate of 0% of any length is tolerable when cash flow is otherwise resilient. It’s reasonably easy to find a secure investment that pays more than 0%.

## Equivalent Rate of Return

Mathematically, paying off a debt is equivalent to investing an amount equal to the principal at an equivalent guaranteed rate of return. Suppose someone has $100,000 in debt with a 5% interest rate, and they place $100,000 cash in a savings account to produce the monthly loan payment. Assume the marginal tax rate is 24%. The savings account must return 6.6%, or 5% after taxes, to make the loan payments and bring the account balance to $0 upon the last payment.

So, the question is, can one find a guaranteed rate of return that is 6.6% or higher for the term of the loan? Outside of series I bonds, guaranteed returns are generally much lower than that.

## At-Risk Investments

Alternatively, the investor could invest at risk. His investment is effectively investing borrowed money or *leveraging his investment*. This choice has two problems: 1) Leverage increases the breakeven return and therefore increases the odds of losing money, and 2) leverage multiplies the equity volatility.

Continuing the above example, suppose one borrows $90,000 and puts in $10,000 out of pocket to invest $100,000. If the loan rate is 5.55% and is not deductible, interest in the first year is around $5,000, or 5% of the gross investment. To break even, the $100,000 investment needs to make $5,000 or 5% after taxes or 6.6% before taxes. A return of less than 6.6% will result in a loss.

In this example, the volatility is also 10 times larger. Assume the investment immediately goes up 10% to $110,000 and the investor immediately sells, avoiding interest costs. The investor will have $20,000 after paying off the loan. That’s a 100% return on the $10,000 of equity. Conversely, a 10% loss in the value of the investment results in a 100% loss of equity. A 20% loss would result in a 200% loss, and so on. Few investors seek to magnify the volatility of their equity.

## Debt and Inflation

Debt can appear to be a hedge against inflation. The fixed payments can shrink relative to income wages or Social Security. when the loan has fixed payments. Say an investor pays 20% of their net income toward their debt. After a few years of high inflation and presumably rising income, the debt payments may only make up 10%.

But paying off debt always comes back to analyzing the offsetting investment. Many investors hold fixed-income positions, such as bond funds, CDs, or individual bonds. Those types of investments can be susceptible to inflation, as well, and so may have reduced returns or even losses.

The same equivalent rate of return analysis applies here. Even in inflationary periods, reducing the fixed-income holdings to pay off debt may make sense.

## Should Debt Be Paid Down?

The question of whether debt should be paid down comes down to considering the guaranteed return of investments, income cash flow risks, and the added volatility of equity. Very often, investors will realize a higher equivalent guaranteed rates of return when investments are liquidated to pay off debt. Furthermore, paying off debt can reduce cash flow risk as well as the volatility of their equity. In all cases, investors should always seek to maintain sufficient emergency cash reserves.

## Speak Your Mind

You must be logged in to post a comment.