Debt Management

January 9, 2023

The adage goes, “A penny saved is a penny earned.” Most people think about this when budgeting their expenses but they should also consider it when managing their debt. Not everyone realizes that paying down a 20% credit card balance contributes the same value to net worth as earning 20% on investment. It does! Let’s talk about the right amount of debt, when to take a loan, and how to build an interest-rate waterfall.

What is the right amount of debt? Many cultures shun debt altogether (Islam deems interest haram or forbidden), and for others at the other end of the spectrum, it’s a way of life! Surprisingly to some, the answer’s usually not zero but somewhere in between. People often mistakenly prioritize paying off debt at the expense of growing net worth. For those looking to optimize their household balance sheet and maximize net worth, carry as much debt as you can afford to pay each month so long as your highest interest rate debt has a lower rate than the expected return on your lowest-yielding investment.

When deciding to take out a new loan, the borrower should ask two questions. Can I afford to make this purchase without the loan? And, is this expense being paid for a necessity to live, or is it a nice-to-have? See the table below for answers:

Can Afford Without a LoanCannot Afford Without a Loan
NecessitiesTake a loan if the rate is lower than other outstanding loansTake the loan
Nice-to-havesTake a loan if the rate is lower than other outstanding loansDo not purchase

This table is a general rule of thumb and there are of course exceptions given certain circumstances, which is why it’s always helpful to talk with a financial professional whose business is to know your relationship with money and help you define YOUR (not the advisor’s) line between necessities and nice-to-haves.

If you have income that exceeds your expenses and proper emergency funds, and you want to deploy excess savings in the most efficient way possible, use the interest rate waterfall. Create the interest rate waterfall by lining up all your loans and potential investments in order of interest rate paid on debt, or earned on investment, from highest to lowest. Remember, the loan balance or the investment value is 100% irrelevant to this exercise. For example:

401k Match100%
Credit Card22%
Personal Loan15%
Private Student Loan6.5%
US Treasuries4.5%
High-yield Savings3%
Federal Student Loan2%
TV Loan0%

Now let the savings flow down the interest rate waterfall, meaningfully take advantage of the employer 401k match before paying down the credit card debt, paying down the personal loan, investing in stocks, etc. The second dimension of this exercise is to evaluate the risk of investing in paying down debt.

For example, stocks probably will beat 6.5% over the long run, but it may not be worth the headache of watching the account value plunge 20% like it did this year, which would favor getting 6.5% risk-free by paying down the private student loan instead. It may also make sense to go against the interest rate waterfall if you anticipate applying for a mortgage, mortgage refinance, or business loan and need to reduce your debt-to-income ratio by paying down loans with high minimum payments.

I challenge you to create your interest rate waterfall to let the savings flow in 2023 and drench you in its financial-optimizing glory!

Tune in next month for a guided tour of not asset allocation but asset LOCATION.

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