Borrow Smart: How to Use Debt Wisely

Key Points

  • Various types of tax-deductible debt can help you borrow more intelligently.
  • We explore the three primary sources of low-rate, tax-deductible debt for individuals: mortgage and home-equity debt, investment debt and student debt.

Investors often overlook the liability side of their balance sheets as they focus on their portfolios and other assets. But your personal net worth has two sides: assets and liabilities. The New Year provides a good time to get the less glamorous side of the balance sheet—your liabilities—into shape.

Your first step is figuring out what overall debt level is appropriate for you. The industry rule of thumb is called the 28/36 rule.

The first number means that no more than 28% of your pretax household income should go to servicing home debt. That includes all home-related debt costs, including principal payments, interest, property taxes and insurance (sometimes abbreviated as PITI).

The second number means that no more than 36% of pretax income should go to all debt payments, including credit cards, auto loans and home debt. As a guideline, consider the following ranges of total debt payments as a percentage of pretax income:

  • Below 30%: Great!
  • 30% to 36%: OK
  • 36% to 40%: Borderline
  • More than 40%: Red flag, especially if you're carrying a lot of debt with variable rates and your income doesn't keep up with rising rates.

The appropriate debt level for you hinges on three things: how much you're paying to borrow money, how you're using it and whether or not the payments are manageable.

Assuming an acceptable level of overall debt, you should then focus on how to minimize your debt payments. Credit cards and unsecured installment loans are among the costliest forms of debt: Their rates are typically in the double-digit stratosphere, and the interest expenses are generally not tax deductible.

Thankfully, individuals still have three primary sources for low-rate loans with tax-deductible interest, if they qualify:

  • Mortgage and home-equity debt
  • Investment debt
  • Student debt

Here are some savvy strategies to help you make the most of them.

Mortgage and home-equity debt

Mortgage and home equity lines of credit (HELOCs) are among the most attractive debt options.1

The interest is tax deductible on mortgage debt up to $1 million on your primary and/or secondary residence, whether for purchase or major improvements. The same is true on up to $100,000 of home-equity debt, which can be used for any purpose. However, check with your tax advisor, especially if you think you might be subject to the alternative minimum tax (AMT): it might be better not to take the mortgage-interest deduction and avoid the AMT.

Any points you might pay when taking out a mortgage loan can be deducted as well—either in the year you pay them (for an original mortgage) or during the life of the loan (in the case of a refinancing). If you refinance with a new lender, unamortized points from a previous refinancing are also deductible in the year of the new refinancing.

Another major—and often overlooked—factor influencing the potential cost and structure of the debt on your primary residence is how long you plan to live in it. If you plan on staying for the long haul (10 years or more), this is still a great time to lock in a low rate for the life of the loan (and shift the risk of rising rates to the lender rather than taking it on yourself).

Many people gravitate to fixed-rate mortgages even if they don't plan on staying put for long. However, if you plan to stay in your home five years or fewer, you could be better off with a variable-rate mortgage—even if rates begin to rise. If you plan on staying fewer than 10 years or so, you might even consider an interest-only loan. Of course, it all depends on your individual circumstances.

Finally, homeowners with high-rate consumer debt (credit card debt, for example) may want to consider rolling it into a low-rate HELOC—but only if they can keep from running up their credit card balances all over again.

Investment debt

Investment interest expense

Investment interest expense is the interest on money you borrow to purchase taxable investments. It's tax deductible up to the amount of any net investment income, and leftover investment interest expense can be carried over for use in future years, without expiration. It's not the source of the loan that matters for tax deduction purposes; it's how you use the money. Here are a few examples of what you might buy with a margin loan, and whether or not the interest will be deductible:

  • Stock: Loan interest is deductible
  • Car: Loan interest is NOT deductible
  • Tax-exempt municipal bonds: Loan interest is NOT deductible

To calculate your net investment income—and therefore how much investment interest expense you can deduct—add up your taxable interest income, ordinary dividends, long-term capital gains and qualified dividends if you make a special election to treat them as ordinary income (more below). Then, subtract any investment-related miscellaneous itemized deductions you actually get to use.

For example: Say you have $10,000 of investment interest expense, $10,000 of taxable investment income and $5,000 of investment-related miscellaneous itemized deductions, $1,000 of which you can use given your adjustable gross income (AGI). Your net investment income is $9,000 ($10,000 in investment income minus $1,000 in allowable investment-related miscellaneous itemized deductions). You could deduct a matching amount of investment interest expense, or $9,000. The remaining $1,000 of unused investment interest expense could be rolled over for future years.

How do the qualified dividend rules impact investment interest expense?

  • Qualified dividends. Qualified dividends that receive preferential tax treatment aren't considered investment income for purposes of the investment interest expense deduction.2 However, you could elect to treat qualified dividends as ordinary income (similar to net long-term capital gain income) to boost the amount you can deduct as investment interest expense. The advantage here is that you pay 0% tax on qualified dividends rather than 15% or 20% tax. Let's go back to our example: If you also have $1,000 of qualified dividends, you could pay 15% (or 20%) tax on them, or you could elect to treat those dividends as ordinary income. This would boost your net investment income from $9,000 to $10,000—and allow you to deduct up to $10,000 in investment interest expense in the current year.
  • Payment in lieu of dividends. If you buy dividend-paying stock on margin and your broker lends out the stock, you don't really receive dividends, you receive payment in lieu of dividends. These payments are treated as ordinary income and aren't eligible for the qualified dividend rate, but they are eligible to offset your investment interest expense, so all is not lost. However, if you already have sufficient ordinary investment income from other sources (or more payment in lieu of dividends than can be used), you're stuck with ordinary tax treatment.

Margin lending

Just as banks can lend you money if you have equity in your home, your brokerage firm can lend you money against the value of certain stocks, bonds and mutual funds in your portfolio. This is known as a margin loan.

Margin loan rates are set by the brokerage firm and generally track short-term interest rates.3 There's no fixed repayment schedule with a margin loan, though you may be required to deposit funds if the value of your account falls below a certain point.

Borrowing on margin isn't for everyone, so it's important to understand the risks. When you purchase investments on margin, you have the opportunity to magnify your return. But the opposite is also true—margin can magnify losses, and you could lose more than your original investment.

However, if your marginable portfolio is large (relative to your level of margin debt) and sufficiently diversified to help mitigate the risks involved, margin loans can be a convenient, flexible and low-cost borrowing alternative—not just to increase leverage in your investments, but for noninvestment uses, as well.

Just remember, with margin debt the IRS tracing rules apply. That means the interest expense is tax deductible if you use the proceeds of the debt to purchase taxable investments and have taxable “net investment income.” Check with your tax advisor.

Securities-based loans

A securities-based loan is a revolving line of credit that's secured by eligible assets and issued by a bank. Assets are held in a separate pledged asset account where you continue to manage them, subject to lender requirements and restrictions. Typically, the money from a securities-based loan may be used for a variety of purposes, subject to the lender's terms. Keep in mind that money is fungible, and funds from different sources can be easily mixed together so that the individual source for each amount can be hard to trace. The IRS tracing rules also apply for interest expense deductibility (see above).

The primary advantages of a securities-based loan versus a margin loan are twofold:

  1. The published interest rate tends to be lower for a securities-based loan compared to a typical margin loan, although most financial institutions will typically negotiate rates for either type of loan depending on the amount borrowed.
  2. Most banks are willing to lend upward of 70% or more on a securities-based loan, compared to the statutory initial margin account limit of 50%.

Securities-based loans are typically used by affluent individuals seeking short-term loans (for example, to provide a bridge loan for a real estate purchase). Check with your lender for rate terms and restrictions and, as always, be sure to check with your tax advisor on interest expense deductibility. Also, keep in mind that these types of loans may be subject to a collateral call (similar to a margin call) if the value of the pledged asset account falls below a certain level.

Student debt

Student-loan interest rates are low compared to other sources of unsecured debt such as credit cards. What's more, interest paid on a student loan can be tax deductible—up to $2,500 per year—depending on your income level.

For 2013, full deductibility is phased out if your adjusted gross income is between $60,000 and $75,000 for single filers and between $125,000 and $155,000 for married filing jointly. So even if you can afford to pay your children's college tuition from other sources, you might want to consider having them take out a low-rate student loan. That way, you can devote your savings to another investment goal—your retirement, for example.

Other considerations

If you have enough resources, borrowing may be purely discretionary and maintaining a manageable level of debt becomes an individual choice based on the numbers involved. For some folks, however, the desire to be debt-free may override other considerations. In that case, opportunity costs and income taxes take a back seat.

Here are a couple of final points to keep in mind, even if you're debt-averse by nature:

  • Liquidity preference. Even if you can't do better with an alternative use of your money, a preference for liquidity might keep you from paying off a low-rate loan prematurely if the opportunity cost is negligible. Diversification could play a role here, as well.
  • Income tax considerations. Everybody's tax situation is different, so check with your tax advisor to see what applies to you. For mortgage debt, don't forget the $1 million debt ceiling is limited to acquisition debt (purchase or capital improvement). Once you've paid off an original mortgage, you'll be limited to the $100,000 home equity deductible debt ceiling unless you make capital improvements or buy another home.

Keep in mind, however, that even at the highest marginal tax rate the cost of borrowing can still be significant (for example, a fully deductible 40% combined tax rate still means you're paying 60 cents on the dollar for carrying the debt).

It's nice to get a deduction on debt you can't avoid, but don't get so wrapped up in taxes that you fail to see the forest for the trees. Stay focused on the big picture—the idea is to minimize expenses, not maximize deductions. If the goal were to maximize deductions, then a 6% rate would be better than a 5%, right?

And why not see if your county will let you pay more in property taxes? After all, it's all deductible. Hopefully, these ideas sound as crazy to you as someone suggesting you borrow more than you need just to get a bigger income tax deduction.

Compare rates and other loan features

Lender rates will vary, depending on such things as the type of loan, where you live, your credit history (FICO score), the amount borrowed, term of years, fixed or variable rate structure, and so forth. The following table compares some recent average rates and features for various common sources of credit. Of course, rates will fluctuate depending on current economic conditions.

 

Original mortgage loan

 

Home equity line of credit

Home equity loan

Securities-based loan

Margin loan

Auto loan

Credit card

Current rates

3.76% (0.32 pts)

5.03%

6.00%

4.51%

7.00%4

4.04%

15.13%

Tax-deductible

Yes (generally up to $1 million for home acquisition or capital improvement)

Yes (generally up to $100,000 for any purpose; AMT may apply)

Yes (generally up to $100,000 for any purpose; AMT may apply)

Tracing rules apply

Tracing rules apply  

No (except for business use)

No (except for business use)

Loan application process

Yes

No (once established)

Yes

No (once established)

No (once established)  

Yes

No (once established)

Flexible repayment

No

Yes (interest-only option generally available)

No

Yes (interest may accrue)

Yes (interest may accrue)  

No

Minimum payment

Source: Bankrate.com, as of February 11, 2013 (original mortgage loan is average for 30-year fixed, auto loan is average for 48-month new car, credit card is average standard variable). Source for margin loan rate is Schwab.com, as of February 11, 2013 (Schwab margin rate shown applies to loans of $50,000–$99,999; base rate of 6.50% last changed on May 20, 2008 and is subject to change without notice). Average securities-based loan rate based on outstanding balance of $250,000 to $499,999.99 as of 3/26/13, provided by Corporate Insight, Inc. Rate levels are for comparison only and are not representative of current levels. Nothing herein is or should be interpreted as an obligation to lend.

The bottom line

The liability side of your personal net worth statement deserves as much attention as the asset side. Just as a well-run business might wisely manage debt to add shareholder value, you can benefit by making smart use of debt within the context of your financial goals. Just be sure you're the master of your debt and not the other way around. Shop for the best terms based on your situation, go for the lowest rates you can find in that context, and take advantage of any tax breaks available to you.

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