Owing money makes many people queasy, even if their assets far exceed their debts. Holding zero debt eliminates that unease and fosters a sense of robust financial safety. There’s nothing wrong with that approach if it helps you sleep at night. However, businesses use debt as leverage to increase their enterprise value faster than they could or would otherwise. Investors can use debt in the same way. Here are four points to consider when considering when and how to use debt.
Hold the debt where it is cheapest. Low rates only – no exceptions.
There are many ways to borrow money. It could be a mortgage, personal line of credit from a bank, home equity line of credit (aka HELOC), student loan or a personal loan. What matters above all else is the rate you’re paying to service the debt. A 22% interest rate on credit card is outrageous. Mortgage loans around 4% are quite reasonable. Seven percent on student loans is not great considering the alternatives. The important thing to remember is you can use your mortgage to finance the early days of your next startup or to finance the cost of college. Your financial life is one big balance sheet and not a series of financial silos.
Know your worst case scenario
Portfolio lending (borrowing against your investments) can be dangerous when taken too far. Fortunately, most firms have been smart about restricting this behavior. It’s certainly not for lack of demand. Warren Buffett reminds us, “When major declines occur they offer extraordinary opportunities to those who are not handicapped by debt.” Ask yourself, “Would I become insolvent if the value of my investments and real estate fell by 50%?” If your answer is yes, you may want to reconsider how your debt impacts your ability to weather a financial storm. It pays to hold dry powder in the event of a major market dip and buying opportunity.
The 10% rule
Using debt safely and responsibly takes a huge amount of diligence – this is why most experts recommend avoiding debt entirely. But debt gives you flexibility and can speed up your ability to grow your net worth. As long as your rates are rock bottom low, holding 10% of your net worth in debt is reasonable and safe.
Inflation is a great thing for holders of debt
Inflation erodes the burden of debt. A $1,000,000 mortgage is worth only about $820,000 after 10 years of a steady 2% inflation. When you go to pay back the loan on your home, you may find that it’s not as expensive as it once seemed. Inflation remains quite subdued now at approximately 2%. Although it is expected to rise there is still no sign that it is doing so. A little more inflation would be good for holders of debt. Re-evaluate your debt level if inflation hits 3%.
We find many investors don’t have a great understanding of how borrowing affects their financial health, or how to use it safely and wisely. It’s a great conversation to have with your advisor. Give us a call if you’d like to explore the topic.
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