Proper Financial Planning is all about allocating your available capital in the most efficient and effective way. Growing your net worth is often a major objective in the overall plan, and there are only 2 ways to do that: Increase your assets or decrease your liabilities. That being said, there should always be a good balance between the amount of capital used to invest (growing your assets) or paying down your debt (decreasing your liabilities). Now, ‘balance’ doesn’t always mean that you should be splitting your capital 50/50 between the two, as there are several factors that play into the equation.
Let’s say that you have some extra cash either sitting around or a surplus in your monthly budget – what should you do with it? This question has been debated, analyzed and answered hundreds of times before, and there is no shortage of opinions from Advisors, Bloggers or Journalists. However, the vast majority of the time, someone is debating that there is 1 solution and that everybody should use that strategy. The reality is, there is no one size fits all solution in the Financial Planning world, and it’s no different in this scenario either.
For those who fall into the ‘excess cash flow’ category, there are generally 3 main options of how that capital can be allocated (not including ‘spending it away’): Invest it, Pay down your debt, or a combination of both. Now, the reality is, one strategy might make more sense mathematically, but whether you can psychologically handle it, is another question. What many Financial Advisors often overlook is the psychology of clients when putting a plan together. Just because something makes sense mathematically, it doesn’t mean it’s the right thing for THAT client. In order for a strategy or a plan to be right for the client, they should feel they are getting full Value out of what they’re doing with their money. This post will approach the topic from a purely psychological standpoint, and won’t take into consideration the mathematical outcome of using one strategy versus the other. In a later post, the mathematical component will be looked at further, to help analyze which strategy would be better from a from a numbers standpoint.
Different people have different ways of thinking when it comes to money, investing or debt. There are some who are very ‘carefree’ in their spending and essentially spend all their money away. There are others who want to put every extra dollar they have into an investment or savings vehicle. Then, there are those who are deathly opposed to debt, and want to put every extra dollar they have to paying down their debt – in most cases, paying down their mortgage as fast as possible.
Now, basic mathematics tells us that, if you’re getting a higher growth rate on the money that’s invested versus the interest rate you’re paying on the debt you have, then it mathematically makes sense to invest the extra cash flow. On the flip side, if you’re paying a higher interest rate on the debt that you have as compared to the growth you’re getting on your investments, then it mathematically makes sense to pay down the debt with the extra cash flow. There are usually several variables also that need to be considered before making a decision, such as, the amount of debt, the type of debt, the interest rates you’re getting/paying, the time horizons, the risk tolerance, etc…, and assessing each of these with your Financial Advisor will help to build a plan that fits you properly.
However, there’s also the psychology of the individual/family that needs to be taken into consideration. As mentioned above, there are those who are opposed to debt or want to get rid of it as soon as humanly possible. Usually the biggest debt that anybody has is their mortgage, and some have been conditioned in their life to pay down their mortgage as fast as they can, so they can have surplus cash flow in their later years to enjoy their life. There are also those who have no desire or intention of paying off their home faster, and want to either spend or save their extra cash flow, so they can do the things they want in life now. The point is, every person has their own unique situation or thoughts in regards to investing and managing debt, and that needs to be a key component to having a sound Financial Plan.
At the end of the day, you need to do what helps YOU sleep better at night. If spending every extra dollar on paying down your mortgage puts the ease in your mind, then do that. If saving every extra dollar for the future puts the ease in your mind, then do that. Or, if you’re comfortable splitting your extra cash flow between saving and paying down your mortgage, then do that – often this is the option that many people opt for, as they can reach both objectives (increasing assets and decreasing liabilities) simultaneously.
Regardless of what type of person you are, it is crucial to have an Elite level Financial Advisor working with you every step of the way. Each component of your Financial Plan should be monitored and reviewed regularly and be right for YOU. From Investment Planning to Debt Elimination Planning, and everything in between, you need to have a proper strategy in place for you, so that you can achieve your goals.
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