Balancing Act
Some debts are fun when you are acquiring them, but none are fun when you set about retiring them.
One of the most common questions that we hear from our clients is: “Should I use my money to reduce debt now or should I start investing and saving first? Can I do both and at what cost?” The answer is not so straightforward and typically depends on your preference. A plethora of self-help books and information online either declare debt as a deadly sin or heaven-sent. Here are some possible ways to think about it.
There are times when it is appropriate to take on a loan or debt — leaving your savings and investments alone. One such occasion is buying a new home or property. Unless you have spare rooms available for you to move in temporarily, chances are you will be buying a new place before selling your old one. The issue then arises: Should you use all your available investments or savings to pay for the bulk of the place? Or, given the low interest rates available now, use whatever liquid assets necessary to cover the down payment and maximise your loan? Then, later on you can use the cash proceeds from the sale of your original house to start paying off the mortgage and increasing your cash account.
If the debt can be incurred with low or no interest, it may make sense to invest first and worry about this debt later on. However, it is important to note that some debt can start out with a low interest rate in the early stages (like credit card debt) but continually balloon the longer you hold on to it. These are the types of debt you should clear first. Home and car loan payments generally don’t have escalating interest payments, allowing you to invest your money and pay off these loans over a longer time frame.
Finally, when thinking about an emergency fund, most people picture cash in a bank account. There’s nothing wrong with that per se, but let’s consider this alternative solution: have an emergency cash portion as a subset of your investment portfolio. This works if your portfolio has an allocation to bonds and cash. These bonds should be very high grade, liquid bonds. This way, whenever you need to dip into your emergency funds, selling off a portion of your portfolio will help you fund it. This also ensures that your money is invested and also earns a higher return than it does sitting in a savings account.
When calculating how large of an emergency fund you need, there are generally two broad categories to consider:
(1) Spending shocks and (2) Income shocks.
For spending shocks, these are items that you will need to pay for no matter what — like car repairs and home repairs. A failing air conditioning unit or oven will definitely force you to dig into your savings to replace it. As for income shocks, consider the following: Do you have the appropriate skillset to switch to another job? Are your skills transferrable? Does your spouse have a steady income? Is your industry potentially on the decline?
Whether or not you have debt, save and invest as early as you can. The long time horizon will give your investments ample time to compound. Budgeting is tough and can take a lot of effort, but reviewing your budgeting framework will help especially as you transition through different stages of life. As always, if you need a helping hand or just a simple second opinion, we are here for you.
