A decade ago I had been with a new organization for two years as a director in the finance team. My salary had grown 30% over the previous 2 years, thanks to hard work, focus and applying all the techniques I’m sharing on this blog. I was aiming for a Vice President role in the next 12 months and lining up all my ducks, so to say. The year was drawing to an end and I was anxiously trying to work out what I would do with my first stock option payout. It was a tidy little lump sum back then and I knew I had to be smart about what I did with it, whether to repay debt or invest the money.
Earlier this year, the same conundrum reared its head, when a far more significant lump sum arrived thanks to a healthy combination of variable pay, stock options and restricted stock units. I have dealt with this situation on numerous occasions over the past decade, but this time I reached a different conclusion.
What made me change my course of action and do something different this time around? What are the key decision points you need to keep in mind and play through when looking at this situation?
You’ll find loads of resources on the internet that’ll tell you to go this way or that. Some will even give you an analysis on the percentage of the lump sum to put against debt versus investments. They can make it sound easy.
The truth is, it is complicated.
There are rational choices, obvious ways to use the money and then there are other deciding factors that are personal to each of us.
Let me walk you through some of the critical points you should be considering that should help you weigh up which way you should lean.
Your debt vs income profile
Your debt needs to be manageable. By that I mean on a monthly or weekly basis, your income needs to be sufficient to cover your debt repayments. By how much? I like to work on a ratio of 25%, meaning your debt repayments should not be more than 25% of your gross income on a weekly or monthly basis and at a maximum 30%. Why 25%-30%? This is just a rule of thumb of course. When looking at median revenues of $4.000 a month, if we assume that after taxes and insurance, one is left with about $2.200-2.300, then a debt repayment of $1.000 (25% of $4.000) leaves you with approximately $1.200 to live on, which should be reasonably manageable.
Everyone needs to establish a good budget before settling in on the ideal debt to income ratio, but that’s a whole other topic that I won’t deal with now. Just make sure you can pay for food, water, clothes and other basics before saddling yourself up with debt.
If you find your debt to income ratio is on the high side of my rule of thumb, then that points to repaying debt being a probable high-priority.
Your debt vs investment profile
Debt is by definition risky. Look at all the stories of being overcome with anxiety, foreclosed on and the plethora of websites writing about reducing debt. It comes with a lot of issues, but it can be a formidable wealth generator.
Leverage, when used correctly can help you build wealth faster than simple investing.
How much debt is a question of your investment profile. Do you like risk?
Elon Musk, after he sold PayPal for more money than any of us can get our head around, invested everything into Tesla and SpaceX, and had to resort to borrowing money from his parents to cover his daily expenses. He was prepared to lose everything he had built up and bet it on his next ventures. Time will tell how that will turn out for him, but clearly he likes taking risks.
When you use debt or leverage, you take on a risk as, at some point, it may arrive that you can’t cover the debt with your income or if the asset that was bought with the debt reduces in value to under the level of the debt.
You need to understand your risk appetite. This will help you identify how much debt you can take on, be it within my 25% rule of thumb or beyond.
What is your debt is doing for you?
Debt should only be used to build wealth. Don’t use it for anything else. Ever.
If your debt is financing a lifestyle, then paying it off should be your absolute priority. If your debt is financing a rental income property in a sought-after area, with good long-term property price growth prospects, then that’s a good use of debt.
If your debt is financing clothes and food. That’s a bad idea.
Student Loan debt financed your intellectual capital. The asset has been created and is now growing through experience. The debt is no longer serving a purpose to help the asset grow. Pay it off as fast as possible.
Debt should only be used to build wealth. When it is not helping build wealth anymore, pay it off as fast as you can.
Current market return outlook and risk in the future
The future is, by definition, unwritten and unknown. We project ourselves into the future by using past trends and experience. There is an inherent flaw in this reasoning, which is shown by the fact that most, if not all, predictions about the future turn out wrong. The fact that the market grew by 8% per year over the last decade doesn’t mean it will continue to grow by 8% per year over the next decade. Be very clear on that. All those experts you read about talking about the future of the stock market have no crystal ball to see into the future.
They’re just extrapolating past results into the future.
They take into consideration what is happening in the present, but as we have no real idea how things will evolve, because the future has not yet happened, we can thus never be sure of the impact the present will have on past trends.
So, if you look at market return expectations and a return on money you can invest versus using it to pay down debt, make sure you understand that those expectations could be completely wrong. They may turn out right, but more often than not, they are completely wrong.
Use expected market or investment returns as just one element to help you decide whether you should pay off debt or invest any windfall.
Your career prospects
Salaries can go up. When they go up your ability to cover your debt payments improves. Salaries can also go down. When they go down, your ability to keep paying your debt payments gets weaker.
Career prospects are a function of a lot of things. I cover some of them on this blog. If you have a focus and a goal that you are diligently working toward, and you are confident your career will advance, then possibly you’ll be ready to accept higher debt ratios to income than if you believe you will be fired soon.
Work as hard on your career, to earn more, as you do everything else. That will help you repay debt faster and invest more.
Your financial and other safety nets
Try not to be in a negative equity position. Negative equity is when your debt is larger than your assets. That is not a fun place to be. How to avoid it? Invest carefully and slowly. Don’t rush into investments using debt. The larger your equity position (assets greater than debt) the more your ability to shoulder your debt at current levels or take on more (debt to income ratios permitting).
Also, in the case of a sudden loss of income, do you have a safety net or other resources that can help cover your debt payments for a reasonable period of time? I always try to keep 6 months of money aside to cover debt repayments as a minimum. I’m not always successful at it, but that’s my goal.
Your safety net may also be family or close friends. The greater and more confident you are in your net, the more you might lean on investing any windfall or lump sum in investments rather than reducing debt.
Your Zen quotient
Does your debt come with anxiety or stress? Do you worry about your ability to cover those debt repayments? Do you wish you were debt free? Or do you see it as essential to building long term wealth and you are thankful for the power of leverage?
The way you answer these questions can give you insight into your Zen quotient. The more stress free your debt is, the more you may lean to investing lump sums elsewhere than repaying debt.
Putting it altogether
No one answer fits everyone. You must address the question from multiple angles to help form a unique solution that fits just you.
Remember a solution from yesterday might not be the same solution for today.
Things change and as they do, so does the approach we will have as to how we use that lump sum: do we repay debt, or do we invest the money elsewhere?
Take your time with these decisions and when in doubt reach out to get our points of view.