Manag­ing your per­sonal debt-eq­uity ra­tio

Moose Jaw Times Herald - - OPINION -

In­vestors of­ten fail to rec­og­nize the im­por­tant role that manag­ing debt has in the success of their in­vest­ment and fi­nan­cial goals. A pe­ri­odic re­view of all your debt and credit obli­ga­tions, with an eye to elim­i­nat­ing or re­duc­ing the amounts owed, the in­ter­est rates be­ing paid or the length of time over which the debt is to be paid off, is a good money man­age­ment habit.

Credit debt creeps up on many peo­ple, usu­ally through overuse and un­der­pay­ment of too many credit cards. That monthly un­paid bal­ance is very ex­pen­sive bor­rowed money that car­ries an­nual in­ter­est rates of­ten as high as 25 per­cent.

Credit cards can be a valu­able debt man­age­ment tool if the bal­ance ow­ing is fully paid off ev­ery month, in ef­fect giv­ing the card­holder a monthly, in­ter­est-free loan. Credit card debt should come off the house­hold books as quickly as pos­si­ble, and one way to do it is to ar­range a con­sol­i­da­tion loan to pay off plas­tic and other re­tail in­stall­ment debts at a much lower bank loan in­ter­est rate.

Mort­gage debt of­ten flies un­der the debt man­age­ment radar screen. It’s a rel­a­tively low-in­ter­est rate loan with a fixed monthly pay­ment that re­sults in home own­er­ship af­ter (typ­i­cally) 25 years. But that eq­uity comes at a price. For most of those years, the mort­gage holder isn’t build­ing much eq­uity, just pay­ing in­ter­est. Only in the fi­nal years of a mort­gage is the bulk of the prin­ci­pal paid off. Mean­while, if pe­ri­odic mort­gage re­newals in­volve re-fi­nanc­ing or an ad­di­tional line of credit, then there’s fur­ther ero­sion of eq­uity and more debt on the house­hold books that needs to be man­aged.

The de­ci­sion to pay down a mort­gage as part of a debt man­age­ment plan should be done with an in­vestor’s over­all long-term in­vest­ment strat­egy in mind. For some in­vestors, mort­gage debt is low-cost cap­i­tal that’s best left in place, while sav­ings are bet­ter di­verted to other in­vest­ment op­por­tu­ni­ties. What works best varies with each in­vestor.

Bor­row­ing for in­vest­ment pur­poses can work to an in­vestor’s ad­van­tage when the in­vest­ment’s rate of re­turn ex­ceeds the cost of the loan. But bor­row­ing to in­vest comes with risks, and this strat­egy re­quires care­ful con­sid­er­a­tion of the de­tails of the debt obli­ga­tions in­volved.

A bank loan to fund any un­used con­tri­bu­tion room in a self-di­rected RRSP is a good idea for many in­vestors. Think of it as bor­row­ing to­day to save more for to­mor­row. The im­me­di­ate tax sav­ings and the long-term, tax-shel­tered, com­pound­ing growth of the added in­vest­ment funds usu­ally out­weigh the cost of the loan. Even bor­row­ing to make or top up a cur­rent year’s al­low­able con­tri­bu­tion may also be a smart idea as long as the loan is paid back within the cal­en­dar year.

In­vestors can bor­row funds and lever­age their in­vest­ments ei­ther with a mar­gin ac­count at their bro­ker­age firm that will ad­vance up to 50 cents on each dol­lar of in­vest­ment (or more de­pend­ing on the se­cu­rity), or with a se­cured loan or line of credit es­tab­lished for in­vest­ment pur­poses at a fi­nan­cial in­sti­tu­tion.

In­ter­est on money bor­rowed for busi­ness and in­vest­ment pur­poses with the in­ten­tion of pro­duc­ing in­come is of­ten tax de­ductible as an ex­pense. Bor­row­ing to in­vest en­ables in­vestors to es­tab­lish a larger ini­tial in­vest­ment po­si­tion than would oth­er­wise be pos­si­ble, and can even­tu­ally gen­er­ate greater re­turns as a re­sult.

But, there are def­i­nite risks. Bor­row­ing for in­vest­ment pur­poses can be a dou­ble-edged sword. If the ex­pected in­vest­ment re­turns don’t ma­te­ri­al­ize, lever­aged bor­row­ing can ac­tu­ally make a bad sit­u­a­tion worse, creating losses that trig­ger a mar­gin call (for more money) if a stock or bas­ket of stocks de­cline in value or, if the bank loan agree­ment re­quires more col­lat­eral to be put up, forc­ing the in­vestor to sell or pledge other as­sets in order to raise the re­quired cap­i­tal.

As a debt man­age­ment strat­egy, in­vest­ment bor­row­ing should in­volve con­sul­ta­tion with a tax pro­fes­sional and a fi­nan­cial ad­vi­sor who can ex­plain the de­tails, obli­ga­tions, and re­spon­si­bil­i­ties of lever­aged in­vest­ing. Your fi­nan­cial ad­vi­sor is fa­mil­iar with the debt man­age­ment strate­gies that can work for you and that might con­trib­ute to your long-term in­vest­ment goals and ob­jec­tives.

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