Debt done right
Day in, day out we hear about the dark side of debt. But done right, debt can be a good thing.
That’s the way Thomas Anderson, author of The Value of Debt: How to Manage Both Sides of the Balance Sheet to Maximize Wealth, sees things. The Chicago-based financial advisor is quick to note that high-interest debt, like credit-card balances, does not qualify as “good” debt. But then there are debts like mortgages. What’s missing from the conversation about debt, he says, is how it can be used to people’s advantage in their overall financial plan.
“Mortgage debt at 2, 3, 4, or even 5 per cent might be debt you don’t want to rush in and pay off so that you can focus on building up liquidity and investment assets,” Anderson says. “People are rushing in on this cycle to pay off debt. But let’s says I have a $500,000 mortgage and win the lottery and have a good size payout of $100,000. If I step in and pay that down and lose my job in the next recession, I can’t access that money. I have no liquidity. I do not have reserves.
“If I end up in a forced eviction, a foreclosure, or a bad situation where what I thought what I was doing was right thing, I’ve painted myself into a corner and eliminated flexibly,” he adds. “Having some liquid investment portfolio, however, I’ll still be in my house able to ride out that storm.”
Whether that storm comes in the form of the tornadoes that recently ravaged parts of Illinois or of something completely different like job loss or illness, Anderson, like most financial experts, suggests having the cash equivalent of at least three to six months’ worth of expenses on hand to deal with emergencies.
From there, he says the golden question is: how much debt should I have? “Zero is not optimal and too high is not optimal,” Anderson says. “Having way too much debt or being debt-averse is not optimal.”
To find the right balance, look to the behaviour of CFOs of major, successful companies, he suggests.
“Some people who have cash will go out and buy aMaserati or a flat-screen TV or plan a trip to Disneyland,” Anderson says. “Some people truly cannot save; having that cash in their savings account burns a hole in their pocket. If you fall in that category and don’t have the discipline to implement these ideas, then all bets are off. But if you think like a rational CFO, a disciplined person who wants to spend less than you make so that you’re saving, then the question becomes where do you direct those savings? You want to be globally diversified and focus on having a combination of offence and defence.”
Anderson also suggests using one or two credit cards but paying them off in full every month to build a good credit score. Having access to a line of credit is another advantage in case of emergency. Putting money aside for retirement is important too.
A good time to use debt wisely
Doug Jones, senior vice president and trustee with BDO Canada Limited, an accounting firm that specializes in insolvency, says that it’s true that debt can be described as “good” when it’s borrowed to obtain an asset or income opportunity that will increase in value over time. Besides mortgages, other examples are student loans, borrowing money to invest, or consolidation loans. However, he notes that even with historically low interest rates, people shouldn’t necessarily be rushing out to owe more money.
“People need to consider the longer term perspective and their individual circumstances … as their debt will still be there when money is no longer ‘cheap’,” Jones says. “When interest rates are low, as they are speculated to remain for about another year, there is a greater opportunity to take on additional debt for things like buying a new home, or doing renovations on an existing house that will add value. So, in that narrow context, now is a good time to use debt wisely. This context, however, has to consider the very large debt loads many people are already carrying.
Canada’s debt-to-income ratio is at an all-time high of 163.4 per cent. “As of the end of September, this debt has grown 2.19 per cent in 2013, on top of the 6 per cent it grew in 2012,’ Jones says. “When interest rates start to rise, which most economists are suggesting will occur in late 2014 or early 2015, the monthly payments on all that debt will rise too," he says.
So what does this mean for the consumer? Your monthly carrying costs -- the price you pay to service that debt -- could rise dramatically, making it difficult to meet monthly bill obligations.
Jones emphasizes the importance of assessing the impact of any given debt over the lifetime of its repayment.
“If people take on more debt, they need to ‘stress test’ their capacity to make payments on all their debt at increasing interest rates,” he says. “Even with these forms of good debt, focused on obtaining assets, the key message is to ensure that the total debt is still manageable. Whether it’s good or bad debt, the monthly bills still need to be paid.”