Financial Planning’s Second Step

Yesterday I talked about the multi-part Step 1 to a financial plan.  Step 2 is straightforward.  Get control of debt.  Debt just means that you have spent money you did not have against the promise of paying in the future.

The world can change.  Beware of long commitments.

If you did your research in step 1 you found that compound interest drives investment growth.  Debt relies on compound interest too, and this time it works against you.  If you discovered that savings, investments and compound interest are what will make your plan flourish, then debt is what will make it wither.

Before we can begin to control debt, we need to know a little more about it.

There is good debt and there is bad debt.  Probably some in the middle too.

Good debt is money you have borrowed to either produce income or reduce some expense.  Maybe a home mortgage instead of rent, although that is a very complex comparison.  A new car versus repairs.

A mortgage on a duplex that you rent is good debt and is not the same as a mortgage on a ski chalet that you use 30 days a year.  The duplex mortgage is very unlike the credit card balance that grew large to buy a vacation or some exotic meals or new clothing.  Debt and interest to finance personal expenses is bad debt.  Student loans tend to be good debt in some ways, because they finance the acquisition of a valuable asset.  The ability to have a good job and earn income.

Interest on debt incurred for personal things is not tax deductible so is more expensive than debt that is tax deductible.  3% non-deductible will mean you need to earn nearly 5% to breakeven. You work out the 22% credit card requirement.

Paying off debt is a high yield, no risk investment.

Where to begin to make it go away?

List all the debts and sort them in order of pretax interest cost.  Credit cards will likely top the list at upwards of 30%.  Any investment loans and in today’s confused world, car loans, will be near the bottom.  Student loans in the middle.

First look at consolidating them into a lower rate loan.  Lock the credit cards in a drawer somewhere.  Start at the top and pay them off as fast as you can.  Once you have eliminated pretax rates higher than 5% or so, you can start to think about renegotiating at better rates still.  Do not believe the first rate you are offered.  Use a mortgage broker .

Plan to pay off all debt.  The good debt idea is just a way to sort the “Should I incur it?” decision.

Now the most powerful debt management method. 

Do not incur the debt in the first place unless it is near certain to pay itself off from new income or savings.  Before you take on any new debt think about where it will fall in the list above.  If you do not like the pro forma list, maybe you can live without the purchase.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Contact:  705-748-5181

This entry was posted in Personal Finance, Planning and tagged , , , , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s