Investors often overlook the liability side of their balance sheet as they focus on their portfolios and other assets. But your personal net worth has two sides: assets and liabilities.
Debt is a tool that isn’t inherently bad or good—it depends on how much you borrow and what it’s used for. But here are a few ideas to help you borrow wisely.
The first step is figuring out what overall debt level is appropriate for you. For this, consider the 28/36 rule. The idea behind the first number is you should aim to have no more than 28% of your pretax household income going toward servicing home debt. This includes all home-related debt costs, including mortgage principal payments, interest, property taxes and insurance (sometimes abbreviated as PITI).
The idea behind the second number is you should aim to use no more than 36% of pretax income to pay all forms of debt, including credit cards, auto loans and home debt. Following this guideline, consider the ranges below of total debt payments as a percentage of pretax income:
- Below 30%: Good
- 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, debt for credit cards or consumer spending, or your income doesn’t keep up with rising rates.
Remember, when it comes to debt, what you borrow the money for matters. Debt used to purchase a home or other long-term asset that could appreciate in value over time is different from debt used to purchase a car, electronics or a vacation. This is important to consider when using debt ratios above.
Other factors beyond debt ratios
After considering your debt ratio and what you’re borrowing for, two other issues are worth considering: how much you’re paying in interest to borrow money and whether the payments are manageable.
Assuming an acceptable level of overall debt, focus on how to minimize debt payments, starting with the highest-interest loans. Credit cards and unsecured installment loans are among the costliest forms of debt. Their interest rates are typically in the double-digits and these interest expenses are not tax deductible.
However, individuals still have three primary sources for low-interest-rate loans where at least a portion of the interest payments could qualify for a tax deduction, subject to certain limitations:
- Mortgage debt
- Investment debt
- Student debt
Here are strategies to help you make the most of them.
1. Mortgage debt
Mortgages have long been among the most attractive debt options, from a tax perspective. Beginning in 2018, the tax code allows taxpayers to deduct interest on debt of up to $750,000 on their primary and/or secondary residence, whether for purchase or major improvements.
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.
Be aware that tax law changes beginning in 2018 removed the deduction for home equity line of credit (HELOC) interest. However, it can still make sense for homeowners with high-rate consumer debt, such as credit card debt, to consider rolling that debt into a low-rate HELOC.¹
2. 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 the interest will be deductible:
- Stocks: Loan interest is deductible.
- Tax-exempt municipal bonds: Loan interest is NOT deductible.
- Car: 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).
For example: Say you have $11,000 of investment interest expenses and $10,000 of taxable investment income. You could use $10,000 of investment interest expenses to offset all the investment income and carry forward the remaining $1,000 of unused investment interest expense to offset income in a future tax year.
How do the qualified dividend rules affect 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 allow you to deduct the full $11,000 of 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.
Just as banks can lend you money if you have equity in your home, most brokerage firms can lend you money against the value of certain stocks, bonds and mutual funds in your portfolio.³ This is known as a margin loan.
Margin loan rates are set by the brokerage firm and generally track short-term interest rates.4 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. 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 for noninvestment uses, as well. If you use margin for this purpose, be aware of the unique features and risks, and have other assets available to repay the loan if the value of your investments fall.
Remember, with margin debt the IRS tracing rules apply. That means the interest expense is only tax deductible if you use the proceeds of the debt to purchase investments and those investments generate taxable net investment income.
A securities-based loan is a revolving line of credit that’s secured by eligible assets and issued by a bank, similar to a margin loan. 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. 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:
- The published interest rate can be lower for a securities-based loan compared to a typical margin loan, and some financial institutions will negotiate rates for either type of loan depending on the amount borrowed.
- Some 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 brokerage firm or lender—including Schwab Bank*—for rate terms and restrictions and, as always, be sure to check with your tax advisor on interest expense deductibility. Remember, 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 specified level.
It’s important to be aware of the unique features and risks of the loan, and have other assets available, if possible, to repay it if the value of investments fall. You should also have a plan to repay the loan, much as you’d pay back a mortgage, in a lump sum or over time.
3. Student debt
Student-loan interest rates are generally low compared to other sources of unsecured debt such as credit cards. In addition, interest paid on a student loan can be tax deductible—up to $2,500 per year—depending on your income level.
For 2017, the deduction for student loan debt is completely phased out once your adjusted gross income is over $80,000 for single filers and over $160,000 for married filing jointly.
Compare rates and other loan features
For all types of debt, lender rates will vary, depending on issues such 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. Be sure to shop around for the best rates and terms before making a decision.
If you have enough resources, borrowing may be purely discretionary and maintaining a manageable level of debt becomes an individual choice based on your other resources and the numbers involved.
For most people, however, the desire to be debt-free may be your most important consideration. In that case, opportunity costs and income taxes take a back seat. At minimum, have a plan to pay back debt as part of a comprehensive investment and financial plan.
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 manage debt to add shareholder value, you may be able to benefit by making smart use of debt within the context of your personal 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 use debt for the right purposes as part of your financial plan.
*Securities based or pledged asset lending involves a high degree of risk. If the value of your collateral declines, you may need to deposit more cash or securities to avoid a default. In addition, your pledged securities could be sold without your consent, which could result in tax consequences. Proceeds must be used for a lawful purpose and may not be used to purchase securities or to pay down margin loans; proceeds may not be deposited into a Schwab brokerage account.
¹ With home equity loans and lines of credit, the financial institution will take a deed of trust to secure the debt. You could lose your home if you do not meet the obligations in your agreement with the financial institution.
² Long-term capital gains and qualified dividends are currently taxed at a rate of 0% for income in the 15% federal marginal tax bracket or lower, 15% for brackets above that level up to the top bracket, and 20% for income that falls in the highest bracket.
³ Not all securities are marginable. Main types that are not marginable include mutual funds for the first 30 days of purchase; unlisted, low-priced, or illiquid equities; and low-rated corporate bonds.
⁴ Interest on your margin loan accrues daily and is posted to your loan balance monthly.