A recent post on Twitter asked, “Why don’t more financial planners advise clients to pay down debt?”
Certainly, many of them do. The reasons others don’t may lie in the type of debt, the age of the client, the advisor’s investment philosophy, and the advisor’s compensation model.
While most advisors would agree paying off short-term debt with high interest rates (like credit cards) is a top priority, not all debt is bad. Debt can be a useful tool for building wealth; like buying real estate, for example.
Nor would many advisors recommend paying off a long-term, fixed-rate home loan with a low interest rate until you have built up some savings. This would include saving for intermittent expenses like car repairs, home maintenance, vacations, and medical bills, as well as a reserve fund for true emergencies like a job loss.
Once those goals are met, and especially if you are young or in a high tax bracket, the wisest move may be to put extra cash toward fully funding your retirement. A good rule of thumb is that 20% to 50% of your take-home pay needs to go toward retirement. The first place to put these funds is in a retirement plan like a Roth IRA, 401k, or an ERISA plan.
Some advisors incorporate debt into their investment philosophy by encouraging clients to “borrow on the margin.” This is a way to double the value of stocks in a portfolio by borrowing 50% of the value. It gives you the potential to supercharge your gains—as well as your losses. It’s not something I recommend, but some advisors and their clients like to live on the edge.
Another reason advisors may not recommend paying down debt is more self-serving. In some cases, reducing a client’s debt also reduces the advisor’s paycheck.
If an advisor is primarily compensated by commissions, any capital that flows to reducing debt will mean less money flowing into financial products that pay commissions. Commissions on mutual funds, annuities, and insurance products range from 1% to 10%. If an advisor has the option of advising you to pay your home mortgage down by $100,000 or use that money to buy a variable annuity with a 10% commission, which choice does the advisor have more incentive to recommend? Very few advisors who would recommend the annuity will tell you the real reason is so they will get a bigger paycheck.
The same is true for investment advisors and financial planners that charge a flat percentage on the assets you give them to manage. While they don’t earn commissions, they do typically earn 1% to 2% annually on the assets, typically billed quarterly. If the dollar amount in the portfolio declines because a client sells assets to pay off debt, their fees also decline accordingly.
Certainly, there are advisors using both these compensation models who will recommend that you pay down debt even if it means less income for them. They are in the minority. Typically these are fiduciary advisors, regulated by the SEC, who have a legal obligation to put your interests ahead of theirs.
The safest way to know that your advisor is truly looking out for you is to select one that is fee-only with charges based on an hourly rate, a flat rate, or your net worth. Under those compensation models, using funds to reduce debt has no impact on their fee.
Whether and how to pay down debt is certainly an important aspect of financial health. Any reputable financial advisor should be committed to helping you manage debt wisely as part of your overall financial plan.
