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?

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 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

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

Breaking down the options for each

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 Build wealth – Investments Monthly investments Salary sacrifice - Super Using leverage = More debt

What to focus your cash flow on

Goals How long until debt has to be paid off Savings Good – Pay down in time to retire, but wait until the last minute to start Bad – Pay down ASAP, but not at the expense of investments 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

Long term rates of 7%, repayments of $3,462 p.m 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 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 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:

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