Why is paying off debt always the biggest priority to advisors?
I have been an active follower of this site and have been around enough financial professionals in my time. One thing I always see and hear is advisors recommending that their clients pay off their debts above all else. Paying off debt seems to be advised over investing, saving, acquiring a loan, a home purchase, etc. Why is it that advisors and professionals are so firm on paying off debts before other options, is there a specific reason? I get that paying off one's debts is crucial, but feel there are other options that should at least be considered as a primary goal for an individual's finances. Are there any advisors who have a similar mindset to mine?
When making decisions about investing, or anything else really, the best path to choose is often the one that requires you to make the fewest amount of assumptions. Clearly no one can predict the future of an investment's return, but we can know for certain that every dollar of unpaid debt will grow at a guaranteed fixed rate (i.e. the stated APR). Thus, we can know with great certainty what the impact of paying down debt will be rather than speculating in the financial markets. In order to justify an investment over debt repayment, the expected return must be higher than the interest rate on the debt.
With that said, it's not always so cut-and-dry. If you have student loans, I wouldn't let that impede you from saving for a down payment on a house. Or if an employer match exists on a 401(k), then this should certainly be prioritized (in fact, I often urge even those with debt to contribute to 401(k) plans regardless of a match to help build the right habits). Every situation is a bit different and needs to be looked at individually.
Many advisors on this site are here to help consumers build and maintain their wealth in much the same way they do for their clients. While paying off debt isn't the most exciting advice, it's often the most prudent. You should beware of the risks of seeking a professional that simply echoes what you want to hear; this would be like a smoker looking for the one doctor that will tell them that smoking is okay rather than to quit.
If you need any clarification or want to chat, feel free to shoot me a message.
Adam C. Harding, CFP
It is mostly a mindset and discipline. What has happened in the past is planners structure debt payments for clients, and they just get into more debt. In other words, some people just don't listen. Giving advice becomes moot because the client does not follow it and planners don't want to see their plans stop. Therefore, getting people to see more than "immediate gratification" (purchasing on credit) or out of necessity is usually the reason for telling people to "get out of debt before buying or investing." It is great in theory because it convinces the person to not use credit because it is a detriment to their finances. But here is the argument, if compounding is the most powerful force in the universe, and you save early, then there will be a nice nest egg at the end! Just the act of saving is the same as the act of paying off debt. It needs to be habitual. I tell people to put away an affordable amount of money per month no matter what the debt load. Get in the habit. Have a disciplined method of getting out of debt, acknowledge the det is there, and then have a plan to reduce it over time.
Good question. The primary reason advisors place such a high priority on debt repayment is because of the negative effects it has on building wealth. The greatest factors that help to build wealth are your income and your savings/ investment rate, but if you are paying a high rate of interest on debt, you are limiting your ability to grow wealth over time. Think about it this way; if you have $10,000 on a credit card at 20% APR, then your interest for one year is $2,000. Let's say you had a great year in your investment account of $10,000 and earned 10%, you just made $1,000. If you had another $10,000 in savings, would you rather earn the 10% return in your investments or the 20% return by paying off your credit card? The reality of the matter is if you are not paying the interest on your debts, then you are essentially earning it. Just another way of looking at things! I hope this helps. If you still have questions, consult with a fee-only financial planner.
This is a great question because it allows us to look at why specific advise is given in a macro-economic environment.
That is prevailing advice because right now, the discount rate, or the rate at which you can expect a safe return, is one of the lowest it has been in recent history. Yet, consumer interest rates are often still not especially low. This means that while a person could reasonably expect a return of 2.5% on a government issued bond, they still might be paying 2-3 times that rate on loans. Therefore, money should flow where it either makes the most interest by direct investment, or by the savings of interest costs paid to another entity. Said differently, it doesn't matter if my $200K investment is doing a 12% average, if I've got a credit card charged to $200K that has an interest rate of 16%. In spite of the great return, I would still be experiencing a net loss of 4%.
The case for not paying down debt would be that if I can finance my $20,000 car for 1.8% and secure a Govt bond for 2.4%, then I should finance the car and invest the $20,000 because I'll be netting .6% (although in this example it should be noted that the .6% must take into account the trading costs, management fees, as well as the potential hassle that such an arrangement can include).
Finally and perhaps most importantly, behavioral finance should be taken into account. This means if a person has consistently blown any liquid money that they have, it might be unwise to use retirement savings to pay off debt even if it makes financial sense. The monthly payment might act as a cap on their spending which if it was paid off, would only facilitate more uncontrolled spending. On this point, I would merely say "know thyself".
In summary, while debt is not the devil, it certainly should be considered in totality of market conditions as well as a person's portfolio. I would also warn that whenever you see a large number of fiduciary advisors giving the same advice, it's most likely sound advice. There are undoubtedly those in the financial world who would be more than happy to lighten your pocketbook by finding an investment that you could invest in rather than pay off debt- regardless of whether it is right for you or not. Those are the "advisors" that you should be wary of, not the other way around.
Like any of the financial tools available to us, debt is just another tool. Used wisely, it can be a good tool to use. When it is used poorly, it increases your risk not have a comfortable lifestyle and future. The fact is, debt can supercharge your finances either up or down.
I do not have a reference point as to how advisors tell people to lower debt all the time. For me, consumer debt (credit card) is always evil. The high cost of interest is never an advantage for you or anyone else. Home mortgage debt is probably a type of debt that is hard to see as negative debt. This advantage is due to the fact most of the time is tax deductible. This fact decreases the interest.
Borrowing to buy a depreciating asset is another questionable financial move. Buying a home is usually a good thing. Real estate is generally an appreciating asset. You need to think that borrowing money to buy a mobile home may not be the greatest idea. Mobile homes depreciate quickly. So much so that there maybe a place in your loan where the mobile home equity will not be as much as the value of it. Both these loans are deductible.
Like everything in life, you need to use good judgment in your decisions to take on debt. An example is college loans. I am a firm believer that a college education is probably a good investment. Taking on $250,000 for an undergraduate education is insanity.
When clients want to pay off their homes when they retire, I usually ask them why. It is the only tax deduction in retirement.
So when taking out loans, think wisely.