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Liability Management: Managing Your Debts

Managing your debts is a key component to managing your overall financial health.  Without careful consideration given to when debt is taken on and for what purpose, your financial picture can quickly deteriorate into a sea of chaos.  Bankruptcy is rarely caused by a lack of income, but instead by becoming too indebted for your particular circumstance.  While some choose to avoid debt altogether for this reason, proper use of debt can enhance your financial health if used properly and in moderation.

Debt can be divided into two categories: good debt and bad debt.  Good debt is taken on to purchase an appreciating asset such as a home or investment such as stocks and/or bonds.  Bad debt is debt used to secure a depreciating asset such as a car or anything generally put on a credit card.  While bad debt provides no benefit to your financial picture and can often become an albatross to your financial health, good debt can be used to grow your net worth and enhance your finances.

One primary difference between good debt and bad debt is the interest rate charged on the outstanding balance.  Since good debt is secured by an asset that should appreciate over time it generally carries a lower interest rate and has tax benefits associated such as the interest rate deduction for your mortgage or margin balance.  Some examples of debts with tax benefits are mortgage debt, home equity loans or lines of credit, and margin loans (when used to purchase securities.)  Debts that have no tax benefit would include auto loans, credit card balances, and personal lines of credit.

In order to manage your debts effectively, you want to consolidate any outstanding balances under the lowest interest rate available to you.  For most, this would be found in your home; either as a first mortgage or as a home equity line of credit (HELOC.)  To some, this would be simply to transfer credit card balances under the lowest rate.  Each credit line available to you has an effective interest rate (interest rate after tax considerations) and credit limit.  To properly consolidate, list each credit line with the interest rate charged as well as the available credit and shift all debts towards the lowest rate.  The following table lists possible credit sources in order of lowest rate to highest rate:

First Mortgage

Home Equity Loan / Line of Credit

Margin Loan

Personal Loan / Line of Credit

Credit Cards

Lenders will generally loan up to 80% of a home’s value on the first mortgage and up to 90% in a HELOC.  The goal is not to avoid debt but to eliminate bad debt for your financial picture.  Credit cards should only be used in the rarest of circumstances and should be for emergencies only.

One common question involving debt is whether or not it is a good idea to pay off your home, if you have the means to do so.  If it will make you sleep better at night knowing that you are debt free then by all means, please do so; however, having the ability to pay off your mortgage is more important than actually doing so.  This entails having an asset base readily accessible to you in taxable accounts that can be used to eliminate the debt at any time.  If those assets generate a higher rate of return than your cost of borrowing, then you are using leverage or debt to enhance your overall financial health.

Another benefit to not paying off your home is that you have liquid assets available to you in the event that you need those funds to pay for things such as health care expenses.  If you had chosen to pay off your home, then you could access those funds through a HELOC, but you would effectively be paying the bank for accessing money that was yours.

Utilizing leverage to enhance your financial picture should only be done with the assistance of a professional financial adviser who can educate you on the risks you face and has the ability to monitor the situation.  It is important to remember that assets can go down while debts remain the same.  If you carry too much debt for both your income and asset base then you may be faced with a financial catastrophe solved only through bankruptcy.

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