Debt is the trans fat of finance

December 15, 2006

Your Money

Politics and religion may be taboo conversation topics, but debt doesn't get much airtime at cocktail parties either. Yet managing debt is one of the easiest ways to improve your financial situation.

In weighing the pros and cons, first analyze what you owe. Itemize your debts including amount, type (mortgage, credit card, etc.), interest rate, and, importantly, whether or not the interest is tax deductible. Tax deductibility is a major factor in the decision and can make the difference between reasonable and reckless debt management. For example, if you're paying a deductible interest rate of 10 percent on a business loan and your tax bracket is 35 percent, your net cost of borrowing is only about 6.5 percent.

To make a fair payoff comparison, first determine whether you can restructure your existing debt to get lower rates or different tax benefits. Perhaps through refinancing or taking out a home equity loan, you can get a lower interest rate.

But the interest rate isn't the only issue involved. Let me address two common concerns I hear from my doctor clients:

"I want to hold the cash in case I have a slow spell and run short." That's an understandable worry. Yet many physicians needlessly pay hundreds, even thousands, of dollars in interest on their existing debt to guard against a potential shortfall that never happens. There are better ways to insulate yourself.

If the need arose, you could tap into other sources of cash that are less costly or more tailored to your immediate needs. For instance, you can often establish a business or personal line of credit without any cost, unless or until you need the funds. Then you can borrow short term and repay as soon as practical while minimizing interest cost.

"I can do better by investing." Sure, you could invest the money and potentially earn a high rate of return. The key word is potentially. You're comparing the guaranteed savings on interest expenses vs the potential earnings from investments. Investment earnings-with the exception of those from certain fixed-income vehicles-are speculative; worse, they're almost always taxable as either ordinary income or capital gains.

You should also compare apples to apples regarding risk. If you have debt at a modest interest rate, say 8 percent, it makes sense to keep that debt only if you can earn more on your disposable cash with virtually little risk. You can't legitimately compare saving 8 percent on debt with possibly earning 25 percent on a risky oil and gas drilling investment.

Even less risky investments that return 7 to 10 percent carry risk of loss, which makes paying off debt the more appropriate choice for many. The decision is even clearer if the debt you're paying off is nondeductible, subjects you to the alternative minimum tax, or carries a higher interest rate.

If you ask a professional for advice about whether to pay off a loan, invest, or hang onto the cash, evaluate the source of the advice. Lenders have little reason to discourage borrowing since it adds to their bottom line. Financial advisers who work on commission, or who are paid by a percentage of assets that they manage, might want you to keep that money invested so that they continue to earn fees on it.

Ultimately, the decision is yours, but managing debt wisely could be the best investment you make.

The author is an attorney and fee-only financial adviser with IFC Personal Financial Counselors ( http://www.objectiveadvice.com) in New York City and Albany, NY. A member of the New York and Massachusetts bar, he's also chairman emeritus of the National Association of Personal Financial Advisors, which represents fee-only comprehensive financial advisers. The ideas expressed in this column are his alone, and do not represent the views of Medical Economics. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics, 123 Tice Blvd., Suite 300, Woodcliff Lake, NJ 07677-7664. You may also send a fax to 201-690-5420 or e-mail to meinvestment@advanstar.com
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