As we near the end of February, my hope is that you and your family are doing well and staying healthy. 2021 is off to an interesting start and as we get back to “normal” (whatever that may be) we have our clients depending on us to bring them excellent direction and advice.
Last month this newsletter focused on the process of bringing on new clients and helping them fully understand their cost of debt so they can make informed decisions on where to allocate their free cash flow.
“When you have clarity it gives you confidence, and when you have confidence you take action”
As I mentioned last month, I lean heavily on my business school experience to help them quantify their cost of debt, as I coined the term Household Hurdle Rate™ or H2R™. This rate is their blended cost of capital which is often very low due to mortgage rates being so low and that is often the largest debt that anyone carries on their balance sheet.
What I have found in my 15 years of being in this business though is that many people don’t know the importance of their H2R or understand how to implement it into their lives. The same is often said for the Average Financial Advisor who may not be familiar with it or haven’t used this approach in the past.
Here is where the magic happens: once a client has clarity on what their debts are costing them, the majority of their free cash flow then is directed to investing and saving. Why? You will see on the other page included in this envelope an example of H2R™ and how it is calculated. You can use this to share with clients if needed since I updated it with 2021 tax tables.
In my quote that I started out this newsletter with, when someone has clarity they then have confidence to take action. How many clients do you have who currently enjoy a very low mortgage rate and ask you if they should pay extra every month in order to pay down their mortgage? I bet more than a few.
Well, someone who has clarity on their H2R then will have confidence on what to do with their money each month – Invest with you! That confidence allows them to take action and everyone benefits with that.
This is the Power of Liability Management and Household Hurdle Rate and how it can help your clients grow their assets with smart management of their debts.
I am here to help if you need it when on boarding a new client or clarifying this concept for an existing client, just email me to set up a time to talk and we can help others get even more clarity on their personal financial world and managing their liabilities.
About the Household Hurtle Rate (H2R™)
H2R™ (Household Hurdle Rate™) is a tool used to calculate the net cost of borrowing assuming the borrower is eligible to deduct mortgage interest. It is the real cost of borrowing (mortgage money) factoring in an allowed tax deduction.
We calculate H2R™ by subtracting the borrower’s marginal tax bracket from the gross cost of the borrowing. In the above example the borrowers Federal+ State tax bracket equals 40% (which is 1.4% of the 3.5% nominal cost of borrowing). Therefore, by deducting 1.4% from 3.5% we arrive at an H2R™ of 2.1%. Money put into paying down the debt or not borrowing (such as a larger down payment on real estate) saves 2.1% whereas funds not put into real estate or withdrawn from the asset cost the borrower 2.1% (not 3.5%).
H2R™ can be used in planning around the following common client conversations:
- Prepay debt or invest
- 15 yr. or 30 yr. mortgages
- Amortized or interest only
- Borrow or pay cash
- Analyze various mortgage options