SBJ: The Debt Arbitrage Strategy

Industry Insight

BY: KENNY GOTT

A primary financial goal for many people is to get out of debt, for the sense of financial freedom this can bring. Your financial picture becomes simpler—no income is diverted to debt repayment, so budgeting is more straightforward, and you may free up significant cash for living the good life.

However there is one “gut check” you may want to consider before deciding to retire a mortgage or car loan.  

The term “arbitrage” means taking advantage of a price mismatch to make a profit. For example, if a store has an item on clearance for 50% off the regular price, and you can turn around and sell it for nearly full price in an online auction, you may be able to enjoy a tidy “arbitrage” profit.

A different kind of arbitrage opportunity exists when you can make more money staying in debt than getting out of debt.

For example, let’s say you inherit a sum of money sufficient to pay off your 2.5% fixed-rate home mortgage. If instead you buy a 4.5% fixed-rate investment product, you’ll earn 2% more each year than the mortgage is costing you. That’s arbitrage. (And each year you pay down the mortgage principal a little, the loan interest on the remaining balance is a little less as well.)

On the other hand, with that same inheritance, but a 6% mortgage, you’d be money ahead paying off the debt instead of investing.

The math is pretty simple—but real life isn’t always so straightforward. There are often indirect costs associated with borrowing money, and with most investments, which could wipe out what might otherwise appear to be an arbitrage opportunity. Or an investment product may change or even disappear. And if the investment is not a guaranteed rate, for example the stock market, then what may have seemed like arbitrage could end up looking like a big mistake…because there is a true risk of losing money in the stock market, or any other non-guaranteed investment.

Also, if you take the arbitrage concept to its logical extreme, you would wish to lower your monthly payments all the way to zero on your low-interest debt, and instead plow all those payments into higher-earning investments. But in the real world you can’t lower your payments to zero, you have to make at least minimum payments. And for every dollar that goes toward paying down the debt, that’s one dollar less that’s available for your household budget. So cheap debt may be an opportunity, but servicing those debt payments is the other edge of the double-edge sword.

Here's an example many can relate to, unfortunately: if you can get 0% interest on a credit card transfer, there will be a minimum payment due each month. If you move more and more debt to that “free loan”, the required monthly payments could grow until there’s not enough income to keep up with those minimum payments, not to mention all your other budget needs. You don’t want to fall off that tightrope.

Also, always keep one eye on how your debt load could affect your credit rating, and therefore your capacity to borrow in the future, especially if your long-term planning includes a home or car loan down the road. If your “debt ratio” (monthly debt payments divided by monthly after-tax income) is more than about 32% of your monthly income, it may be harder to get a loan. Lenders also look at your “front-end” or “housing” ratio: your house payment should be no more than about 28% of your monthly income…any more than that, and banks know borrowers may start having trouble keeping up.

So if you have plenty of income and emergency resources, it may make sense to hold onto a portion of “cheap debt” if some of your assets are growing fast enough to come out ahead. But you may decide that the peace of mind that comes with getting out of debt is worth more than whatever the math says. And that is just fine. Work with a financial professional to analyze your unique circumstances and come up with a sensible debt-management strategy that considers both the math and quality-of-life factors before proceeding.

CERTIFIED FINANCIAL PLANNER^TM professional Kenny Gott is President at Piatchek & Associates and author of the book "Bottom Line Financial Planning". He can be reached at kgott@pfinancial.com.