Summer is here, and as was the case last year, the market seems to be wavering a bit. One of the underlying causes for that is softer economic data of late, and in the first column below, we examine whether the slowdown is temporary or indicative of something more serious.
Another cause is likely the uncertainty about whether or not the debt ceiling will be raised. As I outline in the final column, there are several compelling reasons to think Congress will ultimately raise the debt ceiling before the U.S. government’s credit rating is called into question.
Finally, the financial planning tip covers a question that frequently comes up with clients regarding when it makes sense to pay down a loan. As always, if you have any questions or comments, don’t hesitate to contact us and feel free to forward this newsletter to friends or family if you think they would find it helpful.
Micah Porter, CFA, CFP®
Double-Dip or Just a Soft Patch?
Micah Porter, CFA, CFP®
Over the last few weeks, a spate of economic data has been released that paints a picture of a decelerating economy. Predictably, some have seized on this data to claim that we’re now headed towards a double-dip recession. While that could certainly happen, at this point it doesn’t look as if it’s in the offing.
Since the recovery began, we’ve proposed growth would be moderate and more subject to ebbs and flows than would be the case were this a strong recovery. We based this on the fact that the downturn was driven by the bursting of the credit bubble, and recoveries that follow credit bubbles tend to be tepid and economies require a good deal of time – typically 6 to 8 years – to regain their footing. Academics Carmen Reinhart and Kenneth Rogoff detailed much of this in their book This Time is Different, which culled lessons learned from studying 8 centuries of financial crises.
When recoveries are tepid, headwinds can have a material impact, and in the case of the last few months, two primary headwinds have been rising oil prices (and hence rising prices at the pump) and supply chain interruptions due to the earthquake in Japan. The supply chain interruptions are unquestionably temporary, and most economists believe rising oil and gas prices will prove temporary as well – though the possibility that this won’t happen is certainly a threat to the recovery.
All of the foregoing – along with the widely-held believe that Congress will raise the debt ceiling as I detail below – is why what we’re seeing is likely a temporary slowdown and not the beginning of a double-dip. The business sector is in apparent agreement as well, as surveys show the intent to add to payrolls continues to be positive even in the face of softer economic data. Clearly, there are no guarantees that we won’t experience a double-dip, but based on the data we’re seeing now, it seems unlikely.
Financial Planning Tip – When to Pay Down a Loan
Micah Porter, CFA, CFP®
A balloon loan recently matured on a friend’s car, and her intention was to pay the note. She weathered a barrage of calls trying to entice her to buy a new car. When she arrived at the dealership, she ran a gauntlet of sales people offering fantastic deals, and finally met the finance manager with checkbook in hand. She was committed to paying down the loan until the finance manager told her that they could offer a loan for 48 months with a rate under 2% and the ability to prepay at any time. Based on my advice, she put her checkbook away, as the deal was too good to pass up.
So when does it make sense to take a loan versus paying it down? There are a couple of possible scenarios:
- When you have other loans on which the interest rate is higher – generally, you want to pay down your higher interest loans first. One key here is to remember that most of the time mortgages are tax deductible, so if, for example, you’re comparing your second mortgage to another loan that’s not tax deductible, you need to determine the effective rate paid on your second mortgage.
- When you need liquidity – if you don’t have an emergency fund or if your cash needs over the near term are uncertain, it may make sense not to pay off a loan (or roll what’s owed into a very low interest loan). You don’t want to find yourself in a position in which you’ve exhausted your cash by paying down a loan and have a sudden need for cash.
If you decide not to pay down the loan, there are a couple of key points to making the approach work for you:
- Be very careful about taking out a new loan if it has any sort of pre-payment penalty or upfront cost. Both could drive the cost of the loan up, and if that’s the case, it likely won’t make sense.
- Don’t spend the cash you held back on things that aren’t in your plan. If you didn’t pay down the loan because you have higher interest loans, use the cash to pay those down. If you held onto the cash because of a potential liquidity need, only use it for that need – not for something else because you suddenly find yourself with a “windfall”. If the need for liquidity goes away, pay down the loan.
- If it’s a car loan, don’t add any options – just roll over the existing balance. Car dealers will present you with an array of options – most of which revolve around an extended warranty – which they will add to the loan’s principal. Generally, these services cost more than they save you, so odds are you’ll lose in the long run.
There are certainly times when holding on to cash in lieu of paying down a loan makes sense, but you need to make sure you’re very clear on the details of the loan and you have the discipline to use any resulting cash according to plan.
Question of the Month – What is the Debt Ceiling and How Does it Impact Investors?
Micah Porter, CFA, CFP®
Established in 1917, the debt ceiling is a statutory limit on the amount the U.S. government can borrow. According to National Journal the ceiling was raised 10 times in the last decade alone. It’s worth noting that the debt ceiling will have to be increased because of budgets that were already approved – that we’ve come to this point is no surprise to legislators who only recently approved the 2011 budget.
Posturing about not raising the ceiling is typical. Legislators in the past, particularly those from the out party, often vote against raising the ceiling, secure in the knowledge that the vote to raise the ceiling will ultimately pass. This year, however, House Republicans have made more of an issue about raising the ceiling than usual, claiming that without substantial cuts, they’ll refuse to raise the ceiling. While there is a constituency within the party that would likely favor refusing to raise the ceiling, it’s far more likely that the monied interests within the party would do whatever possible to prevent this from happening.
Failing to raise the debt ceiling would result in having to curtail or delay payments on a host of items including social security, medicare, and debt payments. It would also be the first non-technical default in U.S. history. While few would argue that the U.S. is unable to pay its debts, it would be the first time that our nation proved itself unwilling to do so, even if just for a brief while. The cost of credit would undoubtedly increase as our sterling credit rating was impacted. Higher borrowing rates could easily reverse the current recovery and set us up for much higher debt payments down the line – quite possibly offsetting much of the spending cuts currently demanded by the House majority.
Recently, legislative leaders have been making more positive comments about the progress of the debt ceiling talks. With that in mind and given the host of reasons that failing to raise the debt ceiling doesn’t make sense, it seems highly likely the ceiling will be raised before damage is done to our nation’s credit worthiness.