By David P. Murphy
In today’s investment environment, it’s more important than ever to make sure that all facets of your financial plan are working efficiently. Let’s explore the liability side of your balance sheet and discuss how access to strategic financing solutions can help keep you on track to achieving your goals.
Take a careful look at your entire financial picture in terms of the four pillars of wealth planning: protecting assets from catastrophe, being smart about debt, building wealth and planning for both the expected and the unexpected. If you’re like most people, you probably place the least emphasis on the debt side of you balance sheet. However, it is equally important—especially now. Making sure you structure your debt to your benefit may have seemed less important when your portfolio was achieving double-digit returns, but in today’s environment, it matters more than ever.
There are many good reasons to incur debt—to purchase a home or vacation property, to start or expand a business or sometimes simply because you believe you can obtain a return on those borrowed funds that’s greater than the cost of the loan. What’s important to remember is that taking on debt should ensure that it will not threaten your immediate cash flow or you long-term plans for retirement or hinder your ability to fund your child’s education. Intelligent planning requires that you only take debt with a full understanding of its potential benefits and risks, and that you structure it wisely
All Debt Is Not Created Equal
As a matter of practice, you place your assets into categories, for example, cash, bonds and stocks. This helps balance what you want those assets to accomplish and ensures that your overall portfolio reflects your risk tolerance. But what about your liabilities? You allocate your investment portfolio, and often neglect your “debt portfolio”. It’s just as important that you understand your allocation among the various kinds of debt:
- Unsecured debt like credit cards, which can carry high interest rates and is often structured so you pay interest first, retiring the debt slowly;
- Secured debt on depreciating assets, generally associated with loans to purchase items that will decline in value over time, such as cars or boats;
- Secured debt on appreciating assets, typically collectibles like art and other treasures or a residential mortgage;
- Secured debt on income-earning assets, usually associated with the purchase of an investment property that provides rental income.
In fact, when Wall Street analysts research a company to determine if it’s attractive investment, they look very closely at its level of debt, its structure and its cash flow. This is because too much debt, or poorly structured debt, can undermine the viability of a business.
As an investor, it is also important to evaluate your level of debt, its structure and how this affects your cash flow. The analysis includes a review of these important aspects and measures of debt:
- Total debt service ratio, calculated by dividing all debt service payments by gross income; lenders usually fix a manageable ceiling at 40%;
- Interest versus principal payments. Whether payments are primarily going to ward interest or principal will greatly impact your debt service ratio;
- Total debt ratio, which represents your total liabilities divided by your total assets;
- Current-to-total liabilities, reflected by how many of your liabilities are due in the next 12 months; generally the higher that ration, the more problematic, as your situation would be adversely impacted in a rising rate environment if you need to refinance.
Put Your Debt To Work For You
The key objectives of an effective liability management plan are to reduce overall debt, optimize the cost of borrowing, and manage the risk of interest rate fluctuation. How could you improve your debt portfolio? Lower interest rates? Switch from variable or fixed rates? For example, if your mortgage or other loan(s) has an interest rate that’s higher than today’s historically low rates, you might want to consider refinancing.
One key consideration is the timing of the payments. You may want to think about refinancing your mortgage into a shorter term, which should speed up principal payments so it’s paid off by the time you reach retirement age, when your income will likely be reduced.
Another strategy is to create a liquidity source before it’s needed, using your eligible UBS securities as collateral. This gives you immediate borrowing power without selling assets, whether it’s to pay taxes of take advantage of a time-sensitive opportunity. This strategy allows you to keep your long-term investment plan on track, so you’ll continue to receive the dividends, interest and/or capital appreciation that may accrue. Nevertheless, you may also benefit from borrowing against your eligible UBS securities for planned expenses, such as debt consolidation or tuition payments.
There are many financing solutions to reducing and restructuring your debt obligations. Together, we can assess all aspects of your financial plan. We can explore the features, benefits and risks of each option and implement appropriate strategies designed to optimize your cash follow, enhance your wealth management plan and provide flexible options for meeting everyday needs. You’ll be confident that you are on track to achieve your most important goals.
UBS Financial Services Inc. is a subsidiary of UBS AG. ©2012 UBS Financial Services Inc. All rights reserved. Member SIPC.
David P. Murphy is senior vice president, investments, wealth advisor, UBS Financial Services Inc., The Murphy Wealth Management Group, 1251 Avenue of Americas, New York, NY 10020; 212-626-8895; david.p.murphy@ubs.com.