There are many ways to borrow money. It could be a mortgage, personal line of credit from a bank, home equity line of credit (HELOC), student loan or a personal loan. When done properly, investors can leverage debt to great benefit. While lenders may make efforts to differentiate their offerings, what matters above all else is the rate you’re paying to service the debt. Let’s take a look at the range of interest rates and three other key elements to borrowing.
Hold the debt where it is cheapest
It’s important to explore all options before borrowing. A 22% interest rate on credit card is outrageous. It wasn’t until about 30 years ago through a legal loophole that credit card companies found themselves suddenly able to charge 22% interest. Before that loophole, high-interest rate loans were considered (rightfully so) a scourge on society. That rate probably doesn’t apply to you if you’re reading this, but it makes a point about the potential cost of borrowing and it’s certainly something worth pointing out to your kids.
Mortgage loans around 4% are quite reasonable. Student loans around 7% are not great considering the alternatives. The wealthier you are, the easier it is to borrow more money at lower rates. We’ve seen as low as Libor + .50% (totaling just under 3%) for very large lines of credit secured against considerable wealth. The important thing to remember is that money is fungible, meaning it can be moved from account to account and applied to different projects or investments. You may find the best rates via a line of credit secured against a diversified portfolio or via a refinance of a real estate holding.
Know your limits and your worst-case scenarios
Warren Buffett reminds us, “When major declines occur they offer extraordinary opportunities to those who are not handicapped by debt.” But if you are highly leveraged, a market decline can be catastrophic. Ask yourself, “Would I become insolvent if the value of my investments and real estate fell by 50%?” If your answer is yes or maybe, 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. It also pays to hold extra cash during a personal crisis, injury, or illness. Use debt sparingly, and at low costs, to fund the growth of your balance sheet. We can help you find the right balance and the lowest rates available.
The 10% rule
Using debt safely and responsibly takes a watchful eye – this is why many people avoid debt entirely. But debt gives you financial flexibility and can speed up your ability to grow your net worth. It’s particularly useful in real estate transactions. As long as your rates are rock bottom low, holding 10% to 15% of your net worth in debt is considered reasonable and safe.
Inflation is a great thing for debt holders
Over time, inflation effectively erodes the burden of debt. A $1,000,000 mortgage is reduced to roughly $820,000 after 10 years of a steady 2% inflation rate. After a decade, when you finally go to pay back a loan on a property, 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 practical experience with the various types of debt and how they effect their balance sheet. Using debt safely and wisely can be a very useful tool for wealth generation. It’s a great conversation to have with us if you are interested. Give us a call if you’d like to explore the topic.