Debt is the biggest drag on most people’s finances. Yet much of what I’ve written on this personal finance blog has to do with saving and investing. I’ve hardly mentioned anything at all about debt because I don’t carry much of it. My personal debt/equity ratio is 16.74% and the value of my non-registered investments exceeds the amount of debt that I have outstanding. Having such a low debt/equity ratio puts me in a very strong financial position. A stock market correction, a housing correction or both will not significantly affect my financial position because I haven’t over-extended myself. I won’t be underwater with my mortgage and I’m in no danger of a margin call.
While I’m in an enviable position today, it took years of focus and dedication to eliminate and pay down debt to get where I am. In fact, I’ve spent the last 5 years doing exactly the opposite of what many others have done. Rather than borrowing to the max at record-low interest rates, I’ve refused to take on any consumer debt and have focused on aggressively paying down my mortgage. I’ve taken this path because I believe that debt is the antithesis of wealth.
I don’t think there is much point in trying to build wealth when someone’s monthly bills are in arrears and they live off of credit cards. It also doesn’t help to constantly shift credit card balances from one card to another or to try to pay your credit cards with Lines of Credit. At best these strategies will barely keep your head above water and at worse you’ll just sink deeper and deeper into debt.
I’ve always maintained that what is needed before someone starts to save and invest is a serious commitment to tackling one’s personal debt. Debt is a financial liability and its carrying costs can be crippling. It’s no secret that all non-deductible debt, not just high interest credit card debt, is a wealth destroyer. In North America debt has become such a problem that nearly every day some media outlet is reporting that personal and household debt levels have ballooned to new record highs, while savings rates have again plunged to new historic lows. Before anyone can start saving and investing their way to financial freedom, they really need to address their personal level of debt and eliminate as much of it as possible.
Nearly everyone is familiar with the concept of paying yourself first. It is one of the cardinal rules of personal finance and building wealth. Some interpret it to mean that you pay yourself an amount before paying your creditors. When someone finds themselves in a situation where they have considerable debt, the pay yourself first concept is best applied toward aggressively eliminating that debt. You can consolidate your debt so that you are paying a lower interest rate but the debt is still there and must eventually be repaid. Paying down debt won’t be fun. It takes time and will require one to live within or below their means, but the payoff of being debt-free is well worth the effort.
There is no question that paying off debt is difficult. bit it must be done if one is serious about building wealth. As is the case with most problems, a great way to tackle debt is to break it down to its component parts and begin by eliminating the high interest debt first and work your way down to the lower-interest lines of credit and auto loans, followed by the home mortgage.
Since all debt is not created equal, let’s take a look at the 3 main types of debt. The first type of debt is something that everyone is familiar with: consumer debt. Consumer debt consists of everything from credit cards to lines of credit and auto loans. Credit card debt typically carries the highest interest rate which makes paying them off as soon as possible a high priority. The defining feature of consumer debt is that it is debt that was used to buy something that rapidly depreciates in value over time. So it ends up being a waste of money because, not only does the item quickly lose its value, but you end up paying much more for it because of the amount of interest that you pay on top of the actual cost of the item.
The second type of debt that the vast majority of us carry is mortgage debt. Mortgages are often referred to as “good” debt because they are used to acquire real estate that typically rises in value at the rate of inflation or better. While owning real estate is a cornerstone of building wealth, paying off the mortgage as soon as possible is very important, especially in the early years, because they are structured in such a way that you pay all of the interest up front and the interest paid is not tax deductible.
There are plenty of mortgage calculators available to see how much money in interest charges one can save by accelerating mortgage payments or by making lump sum payments. My view on mortgage debt is that it is still non-deductible debt and should be repaid as fast as possible once all high-interest consumer debt has been eliminated. For me, a paid-off home gives me that peace of mind and a sense of security. Most importantly, is that being debt-free with a paid off home dramatically increases your cash flow and reduces your monthly overhead.
Some argue that because we have been sitting at record low interest rates since the financial crisis of 2008-2009, people nowadays are better off investing their money than paying off their mortgage. While they certainly have a point, I look at the fact that average mortgage interest rates over the past 15 years have been around the 6% mark. So if and when interest rates return to more normal levels I figure I’ll come out ahead. On the flipside, if record low interest rates persist for years to come and the global economy cannot churn out any meaningful growth we could find ourselves in a deflationary environment. In that situation, debt would become far more costly and difficult to service.
The third type of debt is that where the carrying charges on it are tax deductible. So, for example, if a person borrows money to purchase an income producing asset, such as a rental property or dividend paying stock, the interest payments on the outstanding debt are tax deductible. This makes it a powerful wealth-building tool because if someone invests properly, they can acquire assets that will rise in value, pay monthly or quarterly income, and have the interest payments deducted from their income tax. If one was to purchase shares in a Canadian company that pays an eligible dividend, that person would benefit from capital gains and dividend income, both of which are tax-efficient income. My opinion on using leverage is that when it is used, it should be used sparingly by those who can stomach the risks involved. While it can certainly boost returns and many investors have had success using it; it can also magnify losses and should only be used after careful consideration.
If you’re serious about building wealth then take advantage of the record low rates to tackle your debt and remember that every dollar that goes against your outstanding debt is a dollar that is directly added to your net worth! Being debt-free is a major financial achievement. It opens up a whole range of possibilities. With no debt, we only have our living expenses to worry about and if you’re smart with your money, you’ll invest it in income producing assets that will eventually cover your living expenses and then some. At this point you are financially free!