The Importance of Debt Reduction in an Era of Rising Interest Rates and Economic Headwinds

The Importance of Debt Reduction in an Era of Rising Interest Rates and Economic Headwinds

August 01, 2023

Today's economic landscape is even more uncertain than usual. On the one hand, it’s marked by higher interest rates and forthcoming economic headwinds. On the other, we have continued strong economic data and market performance. It’s critical that individuals and businesses alike prioritize debt reduction as a critical defensive financial strategy.   Mounting debt poses significant risks, such as increased interest expenses, reduced financial flexibility, and even bankruptcy. In this article, we explore the reasons why debt reduction is essential in the current market and highlight the benefits it brings in mitigating the adverse effects of rising interest rates and economic uncertainties.

Burden of Rising Interest Rates

As interest rates climb, the cost of borrowing increases, affecting both personal and business loans. For individuals, this translates to higher monthly mortgage payments, credit card interest charges, and student loan repayments. Businesses face increased capital costs for operational expenses and investments. By reducing debt, individuals and businesses can alleviate this burden, freeing up resources for other financial priorities.

Improved Financial Stability

Debt reduction plays a vital role in enhancing financial stability. During economic headwinds, such as market downturns or recessions, excessive debt for individuals and businesses creates tremendous vulnerability. It exacerbates financial stress, making it difficult to weather economic uncertainties – both mentally and physically.

Freedom from Financial Stress

Debt can be a significant and imposing source of stress and anxiety. Constantly worrying about repayment obligations, interest rates, and the potential for default can take a toll on mental and emotional well-being. By actively reducing debt, individuals and businesses can experience a sense of freedom and relief from financial stress. This should lead to improved overall well-being, better decision-making, and a greater focus on long-term financial planning.

Enhanced Creditworthiness

In an environment of rising interest rates, lenders tend to become more cautious, closely scrutinizing borrowers' creditworthiness. High debt levels and poor debt management will negatively impact credit scores, reducing access to credit and making it much more expensive. By reducing debt, individuals and businesses can improve their creditworthiness, increasing the likelihood of obtaining loans with lower interest rates and better terms. This not only saves money but also enhances financial opportunities and flexibility.

Increased Cash Flow

Reducing debt directly impacts cash flow, providing individuals and businesses with more disposable income or operational funds. Lower debt obligations mean more money available to allocate towards savings, investments, reinvestment in business growth, or other purchases . Increased cash flow allows individuals to achieve financial goals, such as building an emergency fund, saving for retirement, or funding education. For businesses, it makes funding strategic initiatives, innovation, and capitalizing on growth opportunities possible.

In fact, redirecting extra cash flow to investment accounts may be more rewarding now than at any time in recent memory. Each year, J.P. Morgan releases long-term capital market assumptions that provide a 10–15 year outlook for investment returns across a wide spectrum of asset markets. Following 2022, a year in which markets left a lot to be desired, they forecasted in the 2023 edition that the expected annual return for US investors on a 60/40 stock-bond portfolio should be 7.20% - a whopping 2.9%increase (annually!) from 2022 and the highest level in over a decade. To the extent debt reduction improves cash flow, directing these sums toward long-term investments is important to think about.

Long-Term Financial Security

Debt reduction is an integral part of achieving long-term financial security. By eliminating or reducing debt, one can accelerate progress towards financial goals, such as homeownership, early retirement, or a comfortable retirement lifestyle. Businesses that actively manage and reduce debt enhance their financial position, paving the way for sustainable growth, improved profitability, and a solid foundation to weather whatever the economy throws their way.

As financial planners, our primary objective is to optimize net worth through proven and efficient strategies. One traditional approach we recommend is adhering to the principle of "paying yourself first" by consistently and regularly saving money. As cash flow improves, savings rates can be increased, resulting in larger balances in savings and/or investment accounts.

When individuals have excess cash and ask whether to pay down debt or invest it, the response is likely "it depends," as personalized analysis is essential before making recommendations. One way to find a solution is by comparing the current debt rates with the expected rate of return on an investment portfolio. In other words, is the interest cost of the debt higher than the potential return from the portfolio? Given the current environment of rising interest rates, debt reduction can be an integral part of an overall investment strategy. For instance, variable interest rate debts like business loans and home equity lines of credit may carry rates above 7 or 8%. Achieving a short-term investment return exceeding 8% can be challenging. Therefore, in such cases, the cost of the debt is likely to exceed the expected return from the portfolio, making it more beneficial to allocate surplus cash toward debt repayment. 

The scions of investing, Warren Buffett and Charlie Munger, often share ever so basic, yet profound, rules for success. Central to their teachings is the risk of debt in most aspects of life. It should be used sparingly and strategically as a tool. A tool that can be very productive and powerful if used appropriately. That said, it’s alluring to improve life – personally and professionally – through easy to obtain debt instruments. We’re surrounded by shiny objects and financial instruments to make these things a quick reality. History teaches us that avoiding those shiny objects makes for superior results over the long term.