By Michael J. Searcy
Let’s consider two forms of debt: consumption debt and investment debt.
Consumption debt comes from buying things you want or need when you don’t have enough cash to pay up front. This could include a car, a vacation, furniture or any number of items. These items are usually paid for on credit cards and can depreciate in value over time or immediately after purchase. For my long-time readers and clients, you know I am not a fan of consumption debt. I believe you should save up in advance for a purchase and pay cash, but I understand that, without a plan, this is easier said than done.
Investment debt comes when you incur debt for something you expect will generate a return on the investment in the future. This could include debt for a rental house, stocks and bonds, timberland or equipment needed in a business that will help generate cash. This could also include debt incurred for certain types of education, such as medical school loans, where you become the “equipment” you’re investing in that could generate future income. In contrast to consumer debt, investment debt may make sense because you anticipate that it will yield a greater return on investment than by not incurring the debt.
The key to debt is managing it successfully.
What do you do when you find yourself with large amounts of consumption debt? Common sense may tell you that paying down your debt with the highest interest should be taken care of first. I agree, BUT there may be times to think in an unconventional manner.
Consider this example: Let’s say you have a car loan, a home improvement loan, and a few credit card debts. Your credit cards have the highest interest rate, followed by your home equity loan and then your car. Absent being able to roll the credit cards and car loan into the home equity loan where you might get some benefit of tax deductibility, maybe you should make minimum payments on everything and direct everything else you can toward paying off the smallest loan. I’m talking about the smallest in size outstanding (not smallest interest rate). When you put all of your extra resources into getting that loan paid off, you can then take everything you were paying on the smallest loan PLUS your minimum payment on the next smallest loan and tackle that second largest debt. Once the second debt is paid off, you can put all the resources you were directing into your first two loans and the minimum of your third debt to tackle it with even greater resources. You can continue this process until you eliminate all debts, but you get the idea. By using this strategy, you can start wiping out your loans faster and faster.
Over time, the objective is to get out of debt and then start re-directing the money you were spending on debt into a savings account for your next new car or an emergency fund. If you can save the same amount of money you’re currently spending to pay down debt, think of how much cash you can save and be able to make your future purchases in cash!
Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this content, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for you or your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Searcy Financial Services, Inc.
The content of this letter does not constitute a tax or legal opinion. Always consult with a competent professional service provider for advice on tax or legal matters specific to your situation. To the extent that a reader has any questions regarding the applicability of any specific issue discussed in this content, he/she is encouraged to consult with the professional advisor of his/her choosing.
Originally published on April 17, 2015 by Searcy Financial Services, your Overland Park, Kansas Financial Planner and Investment Manager.