If you have a lot of debt relative to your assets or your ability to service your debt, developing a plan to reduce your debt load is crucial. But if you then suddenly acquire wealth—via an inheritance, the sale of a business, or a large bonus—your debt may no longer be large relative to your assets.
While it may feel good, paying down debt will not immediately increase your net worth, as many people seem to expect. You can see this in the Display below. If your total assets are worth $5,325,000 and your liabilities total $1,850,000, your net worth is $3,475,000. If you sell $1,800,000 in marketable securities to pay off the mortgage, your net worth will not change.
But now your assets will be dominated by the $2 million home you own free and clear, rather than the $3 million securities portfolio you used to have. Paying down debt can change your risk profile significantly.
The benefit of paying down debt, if any, comes from its impact on your net cash flows and liquidity, which could affect your net worth down the road. Some key considerations are:
The interest rate of your debt and your investments. In general, it doesn’t make sense to pay down debt that costs you 2% by selling investments that are earning 5%; it does make sense to pay down credit card debt at 14% by selling bonds earning 3%.
Taxes. The interest you pay on mortgage debt and some student loans is tax deductible, but other interest is not. Most investment returns are taxable, but some can grow on a tax-deferred basis. Make sure you compare the interest rate on your debt and your investments on an after-tax basis.
Other loan terms. Prepayment penalties may eliminate the benefit of paying off high-cost debt; an imminent interest-rate hike when a lower teaser rate expires may increase the benefit.
Your liquidity needs. It may not make sense to pay down a mortgage if you’re going to need the money soon to pay for your wedding. You might then have to take out a new loan, possibly at a higher rate. Similarly, if much of your money is locked up in illiquid assets, it may be wise to pay down debt that allows the lender to suddenly demand repayment.
- Tara Thompson Popernik
- Director—Wealth Strategies Research
- Anne Bucciarelli
- Director—Wealth Strategies Group
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