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?
There may be a failure to communicate here. When I discuss goals with clients, we talk about things in their lives that they would like to achieve. These may include goals such as a comfortable retirement, or intermediate goals like home ownership, or paying for college.
Debt is one of those things that obstruct or interfere with the attainment of those goals. If the debt is large enough and the cost of that debt is high enough, it can make those goals unattainable. Think of debt and debt service as the inverse of saving and investing. If debt service is high, such as the interest rate on credit card debt (often in the 20% range), paying off that debt is like getting a 20% return on the amount you are indebted.
Without debt, you are not experiencing the “drag” that is the cost of servicing that debt which is interfering with the attainment of your financial goals. That does not mean that people can’t save, invest, and accumulate assets before they have paid off all their debts. They may want a home because they need a place to live, and take out a mortgage because they can’t pay cash. They may buy a car and take out an auto loan because they need transportation. Credit card debt is one of the most common types of debt, and the worst, because the cost of that kind of debt is so high. It may well be an indication that people are living beyond their means. Credit cards should be used as a convenience, not as a way of living large.
As those debts build up and servicing those debts takes a larger portion of your income, it makes it much harder to accumulate wealth.
Does that make sense?
Thanks for writing! Such a great question and so many good answers from our other advisors! I totally get your question because if you look at the richest people and study their stories, it always seems as if debt is a part of their success. In their case, it’s called “leverage” rather than “debt” and it is usually a necessary springboard for them. Why does leverage (which is essentially debt with a purpose) work so well for some people? When could incurring debt be better than paying off bills first?
Any money you borrow and have to pay back is debt. However, if you borrow that money to buy an asset that is likely to appreciate or grow in value, then your debt works as leverage to great profits. Leverage certainly carries a risk that the asset won’t grow (or that it could actually decrease in value), but there exists a chance that it could grow. When you borrow money to pay a bill or to buy food to eat or to buy a car that is depreciating, you know for a fact that the debt you incur isn’t possibly going to earn you anything more. That money is going to be gone when you pay back the debt and you will for sure have less (or no) assets left for what you paid.
The other key factor is the cost of the debt you are incurring. As pointed out by the other advisors, the cost of credit card debt is 12 to 22%. Money that is invested has no guarantee that it will return 12 to 22% or any specified amount. So, you KNOW you will pay a 12 to 22% rate on your debt, but you may or may not receive 12 to 22% on your investments. And if you have money in a bank today or any safe investment, you’ll be making maybe 1% on it because we are in such a low interest rate environment. So, that’s why advisors say you need to pay back debt.
Some debt, like a home loan at 3.75%, represents useful leverage because you are in a home that will likely appreciate and give you a good return while allowing you to borrow at a low rate. So even if you have some debt, you want to continue to own and pay off a home while you do your best to pay down your higher interest debt. During the time you have the home loan debt, you’d still aim to save and invest if possible. A college loan is also usually at a lower rate and gives a good return usually, in the form of a higher-paying career, so it can be a “good” debt that you might continue to pay over the duration of the loan while you use other money to invest and save. A third potential type of positive leverage, though still full of financial risk, is to use debt to finance a new small business. In those instances, I can see the logic and potential worth of incurring debt and not paying it off early so that you can save and invest at the same time.
So, I guess I could say I have a somewhat similar mindset to yours when the debt is a useful, helpful, life-enhancing type of leverage! Thank you for writing!
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
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.
Yes, and I am often criticized for them. The "always pay off debt" line, in my opinion, is lazy planning. I do a detailed analysis of the ability and willingness to take on risk and debt. And then make a thoughtful informed decision based on the numbers and emotions of the client, just like I do when taking on the risk of an investment.
If debt is truly always evil then we should never take on any; none for school, none for a home, you get the idea.
Being a CFA, I like numbers and facts. The fact is that many families can afford to take on debt.
Do some take on too much debt? Yes they do, much like an alcoholic can't have just one drink. My wife has a glass of wine from time to time, and a pint for me. We can stop at just one or two and it is healthy and enjoyable. If we took an "all alcohol is bad" attitude, we would not be as healthy mentally and physically.
If we could not control our use of debt, or if we had unstable income, then our use of debt should be limited. But if you are aware of the risks and actually run the numbers, like a "real" advisors should, then you use everything at your disposal in a risk-conscious way.
Don't be foolish with debt, but also, don't be lazy with your analysis. Have the glass wine, in moderation.
Mark Struthers CFA, CFP®