Borrowing Smart

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
Updated February 17, 2009

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. Now may be a good time to get the liability side into shape.

Your first step is figuring out what overall debt level is right for you. There's an industry rule of thumb called the 28/36 rule. The first number means 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 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 variable rate debt and your income doesn't keep up with rising rates.

If you can manage the payments, then the right debt level for you hinges on how much you're paying for the use of the borrowed money, and what you plan to do with it.

Assuming an acceptable level of overall debt, you should next focus on how to minimize your debt payments. Among the highest-cost forms of debt are credit cards and unsecured installment loans—their rates are typically in the double-digit stratosphere, and the interest expenses are generally not tax deductible.

Thankfully, you have three primary sources for low-rate loans with tax-deductible interest: mortgage and home equity debt, margin loans on securities and student loans. 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 are among the most attractive debt options and not just when rates are near historic lows. 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. Check with your tax advisor—especially if you may be subject to the alternative minimum tax (AMT).

Also, 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 over the life of the loan in the case of a refinancing. 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 less, you're almost certainly better off with a variable rate mortgage—even if rates begin to rise. If you plan on staying less than 10 years or so, you might even consider an interest-only loan. (For more, see Managing Your Mortgage.)

Finally, any homeowner with high-rate consumer debt (credit card debt, for example) should consider rolling it into a low-rate home equity line of credit—but ONLY if you can keep from running up your credit card balances all over again. If you’re an out-of-control spender, the last thing you want to do is put your home at risk to support your habit.

Margin debt
Just as banks will lend you money if you have equity in your home, your broker can lend you money against the value of certain stocks, bonds and mutual funds in your portfolio. This is known as a margin loan. Because margin loan rates generally track short-term interest rates, they're more likely to fluctuate in line with moves by the Federal Reserve. 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, and it's important to understand the risks. If you use margin to purchase investments, you could potentially magnify your return. But the opposite is also true—margin can magnify losses, as well, and you could lose more than your original investment.

However, if your marginable portfolio is diversified enough and large enough (relative to the level of margin debt) to help mitigate that risk, margin 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 only if you use the proceeds of the debt to purchase taxable investments—which excludes a Porsche or trip to Europe. Check with your tax advisor.

Student loans
Student loan interest rates are also comparatively low. 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 2009, full deductibility is phased out if your adjusted gross income is between $60,000 and $75,000 for singles and between $120,000 and $150,000 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 the money you saved to another investment goal—your retirement, for example.

Other considerations
If you have enough resources, borrowing may be purely discretionary. In this case, 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. After all, you can't put a price on peace of mind.

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 as well or better with an alternative use of the money, a preference for liquidity might keep you from paying off a low-rate loan prematurely if the opportunity cost is negligible to you. Diversification could play a role here, as well.
Income tax considerations. 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 (e.g., 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 was to maximize deductions, then a 6% rate would be better than a 5%, right? While you’re at it, 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 or are comfortable with 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, etc. The following table compares 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*	Margin loan**	Home equity loan*	Auto loan*	Credit card*
Current rates*	5.34% (0.37 pts)	5.49%	7.00%	8.48%	6.90%	13.47%
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 (if used to purchase taxable investments; limited to net investment income)	Yes (generally up to $100,000 for any purpose; AMT may apply)	No	No
Loan application process	Yes	No (once established)	No (once established)	Yes	Yes	No (once established)
Flexible repayment	No	Yes (interest-only option generally available)	Yes (interest may accrue)	No	No	Minimum payment

Sources: *Bankrate.com, as of February 11, 2009 (original mortgage loan is average for 30-year fixed, auto loan is average for 60-month new car, credit card is average standard variable); **Schwab.com, as of February 13, 2009 (Schwab margin rate shown applies to loans of $50,000–$99,999)

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.

Important details about margin trading:

Margin trading increases your level of market risk.
Your downside is not limited to the collateral value in your margin account.
Schwab may initiate the sale of any securities in your account without contacting you to meet the margin call.
Schwab may increase its "house" maintenance margin requirements at any time and is not required to provide you with advance written notice.
You are not entitled to an extension of time on a margin call.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment or tax advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Individuals should contact their own professional tax and investment advisors or other professional to help answer questions about specific strategies prior to taking any action based on this information. Past performance is not a guarantee of future results.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained from third-party resources is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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