Financial planning is really about… educating clients about debt (1)

People with non-deductible debt are borrowing whenever they spend. 

A client with debt faces a choice as to what they do with any ‘spare’ income. Option 1 is to use the income to retire some of their debt. Option 2 is to spend the money elsewhere. Only one option can be taken. This means that any decision to take option 2 has the effect of leaving the debt higher than it would be if option 1 had been taken. Taking option 2 makes for a higher debt. Effectively, any money spent on option 2 is borrowed money.

This can be a key thing to remember when clients have large non-deductible debt. These clients might also be spending more than is prudent on lifestyle. It can assist those clients to understand that they are living on borrowed money, and that there is a substantial additional after-tax cost of their spending – the interest that would have been avoided over the life of the non-deductible loan had the money instead been used to retire debt.

The after-tax cost of borrowing is often misunderstood or missed out altogether. As an example: here is the generally-reliable Paul Clitheroe giving the right advice (while taking a cheap opportunity to tell us about his boat!) but perhaps missing the opportunity to tell his client about the real cost of her spending. She has $30,000 owing on personal loans and credit cards and is earning $70,000 a year, meaning her tax rate is 30%.  If she borrows $10,000 at 10%, then the after tax interest rate is 14.28%. She has to earn $1,428 – more than a week’s work – just to pay the interest bill (not to mention the 10 weeks of work to repay the principal). If she borrows that much on a credit card charging 17%, then the actual interest rate is 24.28%. That means almost two weeks work a year just to pay the interest bill.   

Adviser tip – here is how you might suggest it

Can you see these paragraphs in your next client communication:

I recommend that you use all extra money to repay your non-deductible debt. It is important to keep in mind that whenever you spend money that could have been used to retire debt, you are left with a higher debt than you would otherwise have had. This means that you have effectively borrowed to finance that purchase.

The interest rate on your non-deductible debt is ___%. Your tax rate is ___%. This means that the effective pre-tax interest rate is ___%. This means that for every $1000 you spend on things other than retiring debt, you will have to earn an extra $___ every year. After ten years, this adds up to an extra $____.

(Worked example:  The interest rate on your non-deductible debt is 5%. Your tax rate is 40%. This means that the effective pre-tax interest rate is 8.33%. This means that for every $1000 you spend on things other than retiring debt, you will have to earn an extra $83 every year. After ten years, this adds up to an extra $830).

The Dover Group