I wish I had borrowed a million bucks back in March of 2009 as the market bottomed and used the money to buy stocks. With the market up more than 200% since then, my investment would be worth more than $3 million today and I could sell the stocks, pay off the debt, pay some taxes and enjoy my net profit of around $1.5 million. Whistling on my way to the bank! We all wish it were that easy, don’t we?
Should we use debt to buy stocks? Or to buy a home, a second home, a car or to pay for college? Whenever we get questions like these, we try to reframe the question. Instead of asking whether debt is appropriate for a specific investment or purchase, we think it makes sense to step back and consider the structure or makeup of your overall balance sheet. Answer the question, “How much debt should I have on my balance sheet?” Forget about whether or not to finance the new car and instead focus on the amount, structure and cost of all of the debt you have.
Before going further about the amount of debt one might have, let me back up a moment to define the type of debt one might have. As we see it, there are only two types of debt: “good debt” and “bad debt.” Pretty sophisticated, huh? In essence, “good debt” is low-cost debt that you can easily service. Low-cost means the interest rate is low. In today’s low interest rate environment, you should easily be able to find low-cost debt. For example, your mortgage rate should be no higher than 4% today. Being able to easily service your debt means that the debt is structured such that you can easily make the payments. Your income and your reserves should allow you to service your debt even if you are temporarily out of work or even if your portfolio has taken a big hit. Being able to easily service your debt is all about certainty. Put yourself in position to have a very high degree of certainty that you can make it through the tough times, which certainly will come. On the other hand, “bad debt” obviously is the evil twin of “good debt.” It is high-cost debt or debt that is structured such that a temporary drop in income or a market decline could cause you to default.
Now that we agree that we’ll never have debt unless it is “good debt,” let’s return to the question of the appropriate amount of debt. The pure financial answer to this question as taught to me back in business school is that we should have as much low-cost debt as we can possibly get if it is properly structured and if we are highly certain that we can easily service the debt. “As much as we can get, Benton? That sounds risky!” Yes, as much as you can get IF it is properly structured andIF you are highly certain that you can easily service the debt, come what may. These are big IFsand they are to be taken seriously. When they are taken seriously, you’ll find yourself with far less debt than the creditors are willing to lend you. To be more specific, we generally advise clients to avoid all debt except 1) a fixed-rate amortizing first mortgage on a primary residence and 2) a home-equity line for temporary use. In most cases, the interest on the first mortgage and the interest on the equity line will be tax deductible, making your borrowing cost even lower. There are many exceptions to the debt structure I describe here; the most common being debt that is used for income-producing, investment real estate.
Other thoughts on debt:
Interest as Rent: Think about interest as simply the price or cost of using the other guy’s money. Or as the cost to “rent” the money. Be sure that to the extent you are using debt, you are paying the least amount of “rent” possible. If you can rent money for X and invest that money and earn 2X, then you are ahead. The other side of that coin obviously is to rent for X and invest and lose 2X. Then you have a problem. We generally advise against borrowing money to buy stocks.
More on Interest as Rent: The cumulative interest paid over the life of the loan on a 30-year mortgage is far more than the cumulative interest paid over the life of the loan on a 15-year mortgage. While this is true, it doesn’t necessarily make the 30-year loan a bad financial choice. When you think of interest as “rent” then you see why this makes sense. You are simply “renting” the money for a longer period of time and of course the amount of “rent” or interest is going to be higher. Just as a two-week beach house rental will cost twice what a one-week rental will cost.
Structure for Certainty: A 30-year amortization gives you more financial certainty than a 15-year amortization. You can always get a 30-year mortgage and pay it off in 15 years by making extra principal payments each month. But having the flexibility to pay only the minimum required payment is a nice option in the event you have a financial setback.
Common Misconception: “My mortgage has a 7% interest rate but I don’t want to refinance because I only have six years left and most of my payments are now going to principal.” Then refinance for a 15-year term at 3% but make extra principal payments such that the mortgage will be gone in six years. As with your current mortgage, most of your payment will go to principal but with your new mortgage, the cost to “rent” the money will be 4% lower. Always go for the lowest “rent” unless the cost of the transaction is greater than the future interest savings.
Debt in Retirement: Our philosophy is to pay it off before you retire. Even if the pure financial answer is to carry as much “good debt” as you can easily service, we find that the peace of mind in being debt-free is a very important consideration. It ain’t all about the numbers! Sleeping at night has its merits. The gainfully employed, indebted 45-year old worried some during the financial crisis. But he got up and went to work. The retired, indebted 70-year old worried a lot during the crisis. Plan to be debt-free when you hang ’em up.
On Leasing or Buying: You’ll spend much less money on transportation during your lifetime if you pay cash for your cars. This is all about behavior. If my current car is paid for and I am considering going out and leasing or financing a new car, I must first consider that the alternative to a new car is to keep driving my old car. It will save me $400 to drive this old car one more month. And next month I can save another $400. And the next month another $400 . . . etc. The money is piling up . . . I think I’ll drive it a few more years! Additionally, when I am paying cash for that next car, I shop and I delay and I shop and I bargain. Sunroof for $2600? Hmmm . . . think I’ll pass. It is all behavior. Who wants to stroke a check for $50,000 for a depreciating asset? Not me. I think I’ll delay the purchase as long as I can. And when I can delay no longer, I’ll make every effort to stroke a check for $38,000 instead of $50,000. Most Americans fail this test and it is very costly.
We hope this is helpful for you, your children or your grandchildren. Please let us know if you would like to discuss any of these ideas.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.
Turning 64
March 28, 2015Retirement Under Construction
April 28, 2015I wish I had borrowed a million bucks back in March of 2009 as the market bottomed and used the money to buy stocks. With the market up more than 200% since then, my investment would be worth more than $3 million today and I could sell the stocks, pay off the debt, pay some taxes and enjoy my net profit of around $1.5 million. Whistling on my way to the bank! We all wish it were that easy, don’t we?
Should we use debt to buy stocks? Or to buy a home, a second home, a car or to pay for college? Whenever we get questions like these, we try to reframe the question. Instead of asking whether debt is appropriate for a specific investment or purchase, we think it makes sense to step back and consider the structure or makeup of your overall balance sheet. Answer the question, “How much debt should I have on my balance sheet?” Forget about whether or not to finance the new car and instead focus on the amount, structure and cost of all of the debt you have.
Before going further about the amount of debt one might have, let me back up a moment to define the type of debt one might have. As we see it, there are only two types of debt: “good debt” and “bad debt.” Pretty sophisticated, huh? In essence, “good debt” is low-cost debt that you can easily service. Low-cost means the interest rate is low. In today’s low interest rate environment, you should easily be able to find low-cost debt. For example, your mortgage rate should be no higher than 4% today. Being able to easily service your debt means that the debt is structured such that you can easily make the payments. Your income and your reserves should allow you to service your debt even if you are temporarily out of work or even if your portfolio has taken a big hit. Being able to easily service your debt is all about certainty. Put yourself in position to have a very high degree of certainty that you can make it through the tough times, which certainly will come. On the other hand, “bad debt” obviously is the evil twin of “good debt.” It is high-cost debt or debt that is structured such that a temporary drop in income or a market decline could cause you to default.
Now that we agree that we’ll never have debt unless it is “good debt,” let’s return to the question of the appropriate amount of debt. The pure financial answer to this question as taught to me back in business school is that we should have as much low-cost debt as we can possibly get if it is properly structured and if we are highly certain that we can easily service the debt. “As much as we can get, Benton? That sounds risky!” Yes, as much as you can get IF it is properly structured andIF you are highly certain that you can easily service the debt, come what may. These are big IFsand they are to be taken seriously. When they are taken seriously, you’ll find yourself with far less debt than the creditors are willing to lend you. To be more specific, we generally advise clients to avoid all debt except 1) a fixed-rate amortizing first mortgage on a primary residence and 2) a home-equity line for temporary use. In most cases, the interest on the first mortgage and the interest on the equity line will be tax deductible, making your borrowing cost even lower. There are many exceptions to the debt structure I describe here; the most common being debt that is used for income-producing, investment real estate.
Other thoughts on debt:
Interest as Rent: Think about interest as simply the price or cost of using the other guy’s money. Or as the cost to “rent” the money. Be sure that to the extent you are using debt, you are paying the least amount of “rent” possible. If you can rent money for X and invest that money and earn 2X, then you are ahead. The other side of that coin obviously is to rent for X and invest and lose 2X. Then you have a problem. We generally advise against borrowing money to buy stocks.
More on Interest as Rent: The cumulative interest paid over the life of the loan on a 30-year mortgage is far more than the cumulative interest paid over the life of the loan on a 15-year mortgage. While this is true, it doesn’t necessarily make the 30-year loan a bad financial choice. When you think of interest as “rent” then you see why this makes sense. You are simply “renting” the money for a longer period of time and of course the amount of “rent” or interest is going to be higher. Just as a two-week beach house rental will cost twice what a one-week rental will cost.
Structure for Certainty: A 30-year amortization gives you more financial certainty than a 15-year amortization. You can always get a 30-year mortgage and pay it off in 15 years by making extra principal payments each month. But having the flexibility to pay only the minimum required payment is a nice option in the event you have a financial setback.
Common Misconception: “My mortgage has a 7% interest rate but I don’t want to refinance because I only have six years left and most of my payments are now going to principal.” Then refinance for a 15-year term at 3% but make extra principal payments such that the mortgage will be gone in six years. As with your current mortgage, most of your payment will go to principal but with your new mortgage, the cost to “rent” the money will be 4% lower. Always go for the lowest “rent” unless the cost of the transaction is greater than the future interest savings.
Debt in Retirement: Our philosophy is to pay it off before you retire. Even if the pure financial answer is to carry as much “good debt” as you can easily service, we find that the peace of mind in being debt-free is a very important consideration. It ain’t all about the numbers! Sleeping at night has its merits. The gainfully employed, indebted 45-year old worried some during the financial crisis. But he got up and went to work. The retired, indebted 70-year old worried a lot during the crisis. Plan to be debt-free when you hang ’em up.
On Leasing or Buying: You’ll spend much less money on transportation during your lifetime if you pay cash for your cars. This is all about behavior. If my current car is paid for and I am considering going out and leasing or financing a new car, I must first consider that the alternative to a new car is to keep driving my old car. It will save me $400 to drive this old car one more month. And next month I can save another $400. And the next month another $400 . . . etc. The money is piling up . . . I think I’ll drive it a few more years! Additionally, when I am paying cash for that next car, I shop and I delay and I shop and I bargain. Sunroof for $2600? Hmmm . . . think I’ll pass. It is all behavior. Who wants to stroke a check for $50,000 for a depreciating asset? Not me. I think I’ll delay the purchase as long as I can. And when I can delay no longer, I’ll make every effort to stroke a check for $38,000 instead of $50,000. Most Americans fail this test and it is very costly.
We hope this is helpful for you, your children or your grandchildren. Please let us know if you would like to discuss any of these ideas.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.
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