One reader recently asked a group of financial planners, “Why is paying off debt the biggest priority to advisors?” So, what is it about debt? Why such a big deal? Why do financial planners always seem to be so obsessed with telling clients to pay off debt?
I don’t know about other advisors, but in my case, you’d trace it back to Mr., Jennings and Mrs. Hirschfield, my high school English teachers who made us read Shakespeare. It’s probably because of what Shakespeare had Polonius say, “Neither a borrower or a lender be.”
Financial planning is all about balancing needs and wants with resources. So, yes, you’re right to think that there are other things you can do with money like investing or buying a home. And no, there’s nothing that says you have to do one thing exclusive of the other goals. In fact, a good financial plan will balance these competing goals and time frames.
Good Debt and Bad Debt: Limits to Consider
Now there’s nothing inherently wrong with debt or credit in general. Debt is really nothing more than another tool in the toolbox for a family or business or even government. And there is the notion of “good” versus “bad” debt. Debt to finance a long-term purchase like a home or to invest in new skills through education that may yield you a higher lifetime income is what we would call “good” debt. Taking out a loan to buy scratch tickets or to pay for day-to-day needs like food or entertainment is something we would call “bad” debt.
And with too much debt (good or bad), you’ll be hamstrung and won’t be able to make other choices. And often the cost of debt is higher than the potential reward one may receive from an investment. Example: There are few moderately risky investment options paying close to 13%-18% per year which is what a credit card may charge you.
Also, too much debt may make it difficult to buy a home. As a former mortgage banker, I can tell you first hand about the anguish potential home buyers would experience when I told them that they had too much debt to afford the home they wanted to buy. Often, the best way to make it possible to afford that home is to pay down debt to where there were 10 or fewer monthly payments remaining.
The Household Spending Plan: 50/30/20
In reality, the most effective plan is one that balances investing, saving and paying off debt. This is why I regularly advise folks to follow a 50/30/20 plan when it comes to use of net, after-tax cash flow. In this plan, you’re addressing current needs as well as repaying debts and saving for future goals.
Fifty-percent of net earnings is allocated for fixed overhead – everything from rent or mortgage payments to loans to utilities to groceries. Thirty-percent of net earnings is allocated to discretionary things – vacations, entertainment, dining out, fancy new personal electronics or hobbies.
Twenty-percent of net earnings is allocated toward savings. This can also include prepayment of other debts as that is a form of savings. It also covers funding your emergency reserve and supplemental retirement accounts (i.e. Roth or traditional IRA) as well as workplace retirement plans.
