The strategic side of debt

Why debt reduction should support – not define – your wealth strategy

Reducing or eliminating debt might feel like the ultimate financial milestone, but paying off debt early – or avoiding it entirely – can limit future opportunities for building or preserving wealth. During periods of volatility, it may be tempting to get rid of debt for short-term relief, but this could compromise your long-term plan. Staying the course may be crucial to your goals – no matter the market.

That’s because sold stocks can’t grow – and neither can uninvested discretionary income. An approach that looks at the whole picture – interest from debt, cash on hand and investments – considers your near-term needs and wishes along with your long-term goals.

The tradeoff

If the interest on your debt is low, finding the right balance of debt, cash and investments may seem more straightforward. With low interest rates – like those available to qualified mortgagees in the 2010s – it’s easier to feel confident that investing excess income is the right move. The investments will likely yield more than the cost of borrowing, so the money is working in your favor.

But, generally, deciding whether it makes sense to pay off or incur debt can be complicated. It’s not as simple as comparing interest rates. You’ll want to consider factors like investment growth potential, taxes, liquidity needs, market conditions and your overall financial goals.

A central principal in these decisions is called the time value of money – the hypothetical value of an investment over a long period of time compared to its current value. In other words, a dollar today can be worth more than a dollar tomorrow because today’s dollar has the opportunity to grow. For example, if you use $10,000 to pay down debt, that money is no longer available to invest and potentially compound over time.

The numbers

The principles of long-term investing encourage investors not to try to “time” the market for maximum gain. Generally, when one invests, one invests over a period of time, smoothing out the daily fluctuations of an investment’s value. When one withdraws, long-term wealth building strategies suggest it’s a good idea to do that over time, too.

If you were to sell investments suddenly to pay off a debt, you would be trying to time the market whether you mean to or not.

The growth of a theoretical stock portfolio across a 20-year period dropped by almost half without the 10 best-performing days in the market. It dropped almost three times after missing the top 20 days.* That’s why staying invested can be so important. The market historically has had a tendency toward growth over time, but it often relies on specific strong-performance days to do so. It’s difficult to predict when those top trading days will occur, and missing only one can diminish the potential performance of a long-term investment.

The strategy

Adopting a strategic approach to managing debt may provide greater confidence compared to simply aiming to eliminate debt. By carefully managing your debt and understanding its role in your financial plan, you can help achieve a more balanced and less stressful life.

Some general guidelines to consider:

• High-interest debt (over 10%) like credit cards and personal loans should be eliminated first.
• Low-interest debt (typically below 5%) can be a valuable financial tool. For example, a low-cost mortgage at 3% might be better retained for tax and liquidity benefits.
• For debt with interest rates between 5% and 10%, plan carefully based on your net worth and financial goals. Consider seeking help to determine a strategic plan for striking a balance you’re comfortable with.

The most effective financial plans don’t revolve around one metric, like debt reduction. They’re designed to align every financial decision to what matters most to you. By considering your entire financial position, priorities and timeline, you’ll be able to make decisions that support both your current and long-term goals.

Past performance may not be indicative of future results. There is no assurance these trends will continue. The market value of securities fluctuates and you may incur a profit or a loss. This analysis does not include transaction costs which would reduce an investor's return.