Using debt constructively When properly managed, smart borrowing can be a useful component of your financial toolkit hom e mortgage car paym ents credit cards savings and i nvestm ents fixedinterest loans cash and cash alternatives As featured in WORTHWHILE, a quarterly periodical dedicated to serving the clients of Raymond James advisors and affiliated advisory firms.
When you think about managing your net worth, you re likely thinking about the assets side of your balance sheet, trying to grow them as much as possible. But net worth is assets minus debt. If you re focused only on one side of your balance sheet, you may be missing half the picture. That matters because smartly managing and using debt can help improve your overall financial situation. It s true that debt often conjures thoughts of irresponsibility, overblown fiscal budgets and the housing crisis. You may even consider debt undesirable, a four-letter word that isn t discussed in polite conversation and has no place on your personal balance sheet. But the truth is borrowing comes in many forms. While borrowing beyond your means can be very harmful, especially if it s high-interest debt, there are instances when debt may be helpful. The key is to understand and respect the difference, know your debt-to-income threshold how much debt you have compared to your liquid assets and use debt wisely. Constructive vs. destructive debt It may seem counterintuitive, but so-called good debt, like mortgages, student loans in some cases, and business financing, can actually enhance your financial position and help build wealth. In fact, constructive debt can potentially help you enjoy the things you want in life, effectively manage liquidity, grow your net worth and establish an excellent credit rating. Additionally, these types of loans often offer a low total cost of borrowing. Destructive debt has the opposite effect, eating away at your credit rating and putting you in a vulnerable financial position. Bad debt is usually associated with buying things you simply don t need or can t afford. For example, you may just need a reliable car to get to work, but you likely want the luxury SUV with all the bells and whistles. If you can comfortably afford the latter, that s great. If not, it s time to reconsider where your money goes. Whether constructive or not, too much debt and what s too much is different for everyone can be problematic. Mismanaging debt, too, can put you in a precarious financial situation. For example, let s say you owe $5,000 on a credit card with a 16% interest rate. If you only pay the minimum each month, that debt will take you more than 27 years to pay off and you ll have paid the principal many times over in interest alone. And that s assuming you don t accumulate more or that your interest rate doesn t rise in all that time. Being overleveraged can derail you from increasing your net worth and securing a comfortable retirement. That s why it helps to understand your debt-to-income ratio, the percentage of your monthly gross income that goes toward paying obligations. It s calculated by adding up how much you spend on obligations each month, then dividing it by your pre-tax monthly income. Multiply that number by 100 to get the percentage. Your debt-toincome ratio is a good indicator of your overall financial health at your current income. Also it s important to stress test this ratio for scenarios like a sudden drop in income due to an Debt ratio example Gross income (income before taxes and other deductions) 28% Front-end ratio includes expenses such as: Housing costs Mortgage Rent Insurance Property taxes 100% 36% Back-end ratio= Front-end ratio plus recurring debt such as: Credit card balances Car payments Student loans Child support Alimony
emergency or job loss. Lenders may talk about similar, but different, debt-to-income ratios. What s known as the front-end ratio describes how much you re paying for housing, be it rent or a mortgage, plus insurance, property taxes and other related fees. Your back-end ratio includes those housing costs, as well as what you spend on recurring debt, like credit card balances, car payments, student loans, child support and alimony. So if your lender is looking for borrowers to have a 28/36 ratio, that means your total housing expenses shouldn t exceed 28% of your gross annual income (income before taxes) and your housing costs combined with Smart borrowing recurring debt shouldn t exceed 36%. Many lenders consider both your debt-to-income ratio and your credit score before qualifying you for a loan, and the ratio they re looking for varies among different institutions. But generally speaking, 36% or less is considered a healthy debt load for most people. Ratios higher than that may cause difficulty when you re trying to secure a loan. Match the loan to the need Before looking into loans that may make sense for your particular situation, you need to understand that liabilities must be managed just as thoughtfully as assets. When you look When managed correctly, debt can be a useful tool, especially in a low interest rate environment. Borrowing in a tax-efficient way has a place in just about any properly executed investment plan. The key is to consider each facet of debt strategically. Choose the option most suited for your particular needs and be sure it fits within the context of your overall financial plan for both short- and long-term time horizons. As you make your decisions, think about: 1. How much debt you re willing to take on 2. Whether you prefer to sell assets or borrow 3. The anticipated rate of return on your investments 4. The anticipated cost of borrowing 5. If it makes sense to borrow in the name of a trust or business 6. What loan structure makes the most sense: traditional, adjustable-rate or collateral-based loan, among others 7. Whether you prefer to use securities, your home or some other asset as collateral 8. Tapping into the equity in your house, especially if rates are attractive 9. The tax ramifications of a loan compared to selling investments 10. How quickly you need the money 11. How long you ll need the loan, particularly a mortgage 12. How you ll pay off a loan and when carefully at both sides of your balance sheet, it makes it easier to achieve long-term financial stability as well as your more immediate objectives. For everyday items and smaller purchases, most of us rely on the convenience of a credit card. Those with good credit may have tens of thousands of dollars at their disposal, all on a little piece of plastic in their wallet. The cards, of course, come with a price, which may make them less attractive when compared to other borrowing methods. If not paid off each month, you ll incur interest-rate charges on the loan, which currently average around 15%. Some cards also charge an annual fee. It may be worth it to you to be able to easily pay for purchases and collect points or earn cash back or other perks through an associated reward program. You can always use the credit card, pay the balance each month and use the cash earned to fund other purchases. The point is to know the pros and cons before relying heavily on your card. On the other hand, if you re looking for a home or a new car, you may consider paying cash or using debt. If you choose the latter, you ll need a more sizeable loan. Loans for these types of Credit card debt can be costly. Consider paying off your balance each month to help build credit and earn rewards without incurring finance fees.
Interest rate Monthly payment Annual payment Total interest Total payment Purchase price: $250,000 15-year mortgage 30-year mortgage 3.25% 3.75% $1,757 $1,158 $21,080 $13,893 $66,201 $166,804 $316,201 $416,804 purchases aren t as easily available as credit cards, especially after the recent housing debt crisis. However, there are many alternatives to pursue: traditional fixed-interest loans, adjustable rate mortgages and lines of credit, secured by your brokerage account or equity in your home. Financing large purchases in this way means you can take advantage of current low interest rates, maintain liquidity, fund investments that may outpace the loan costs and potentially take a tax deduction. These loans also often come with more favorable borrowing terms when compared to credit cards, but they may require a good credit score, extensive documentation and a significant down payment. Again, it s important here to match the right loan to the expected use. The average family stays in their home for seven years, yet the majority of homeowners take out a 30-year mortgage. If you don t plan to stay in your home that long and can afford to pay a little more each month, a shorter term might make more sense and cost you less in the long run when you calculate how much you ll pay to cover the principal and the interest rate. Let s take a look. You ve got your eye on a beautiful 4/2 in a neighborhood with great schools. The sellers want $250,000. A 15-year loan could save you considerable money over a 30-year term, even though it comes with higher monthly payments. Alternative borrowing solutions for larger amounts include margin loans and securities-based lines of credit, both of which use stocks, bonds and mutual funds in an investment account as collateral. Loans, backed by securities or other assets, can help you access anywhere from thousands of dollars to millions, and they each have specific uses. Margin loans can be used for almost any purchase, including buying securities. Securities-based lines of credit are almost as flexible, but those funds cannot be used to purchase additional securities. These sources of liquidity are intended for higher-net-worth borrowers and may be available at competitive interest rates. And, you might be able to establish flexible payment terms on your own schedule. Of course, the loans will need to be repaid eventually and come with their own unique risks, so you and your financial advisor will need to discuss those risks and plan how you ll make the payments. One option may be using the income generated by your In case of emergency Life has its way of surprising even the best planner. An emergency fund, a financial safety net of sorts, can help you weather the unexpected. The general rule of thumb is to have enough money to cover six months or more of your living expenses in an account that s accessible enough when you need it, but not so accessible that you re tempted to borrow from it for everyday purchases. Your emergency resources don t have to be all cash. You can sock away a few hundred dollars in a savings account, certificate of deposit or money market account to serve as your emergency fund each month. As you re building up the fund, you may consider filling in the gap with a high-limit credit card that you only use in emergencies. Credit cards are accepted almost everywhere, including abroad, and are a ready source of liquidity without having to carry cash with you. But use your card with caution; it may still pack a high-interest-rate punch if not paid off promptly.
investments to pay it back along with liquidating securities at a more appropriate time. However, keep in mind that if the value of the underlying collateral declines, you may be forced to sell securities to pay back the loan. If you already own a home, a home equity line of credit (HELOC) offers a source of liquidity with some tax advantages, as well. You can usually deduct the interest on up to $100,000 of HELOC funds that can then be used to improve your home or pay off higher cost debt. Prepared for anything Having ready access to liquidity through a loan also puts you in a position to act quickly should opportunity or an emergency arise. In the first case, your saved cash can be invested, potentially earning a much higher return, and you ll have liquidity for other goals. Perhaps you find the perfect cabin while on vacation or you want to invest in your business. Instead of liquidating your investments, you can tap into a home or securities-based line of credit or other loan that allows you to make an allcash bid for a property, while keeping your investment portfolio intact. If you prefer, you could later refinance after the deal closes. Should the unexpected happen, say a job loss or a hefty tax bill, you ll be prepared for that, too. In the meantime, you ll be able to participate in potential market appreciation without disrupting your investment strategy. Staying invested has historically helped investors capture market gains over the long term. The nearby chart shows how missing even some Time in the market makes a difference Staying invested in the market (1992-2011) helped you better capture market gains over the long term. Missing just some of the best market because you had to sell out of established positions may have adversely affected your portfolio. Annual return 10% 8% 6% 4% 2% 0% -2% -4% 7.8% Invested for all 5,042 trading 4.1% 10 best missed of the best of the market could adversely affect your expected return. Keeping your portfolio positions also means you won t incur capital gains taxes as you would if you sold appreciated securities. You also may be able to borrow at a lower rate than the return you expect from staying invested in the markets. -0.4% 30 best missed -4.0% 50 best missed Past performance is no guarantee of future results. Investing involves risks including the possible loss of capital. This is for illustrative purposes only and not indicative of any investment. Stocks in this example are represented by the Standard & Poor s 500, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs, which would reduce an investor s returns. An investment cannot be made directly in an index. 2013 Morningstar. Using debt strategically Taking a close look at how your assets and your liabilities work together can help you achieve long-term financial goals. Let s take a look at mortgages. Almost every homeowner has one, and many probably want to pay it off as soon as possible out of an ingrained belief that being debt free is best for their financial plan or just for peace of mind.
Borrowing and paying off a loan and consistently paying on time helps establish an excellent credit history and could result in lower interest rates and fees on subsequent borrowing In fact, many people would say paying cash or paying off a mortgage early is the most conservative way to buy a house. However, a home mortgage likely is one of the cheapest ways to borrow money and the interest is usually deductible, making it even more compelling. Paying off your mortgage early also means a large portion of your net worth will be tied up in one of the most illiquid assets out there. Just selling a house to get the cash back out will require 5% to 10% in transaction costs, from listing to close, and could take you longer than six months to realize the cash compared to just three for selling securities. Let s say you re thinking about using money from your brokerage account to pay off your long-term mortgage. Should you? Sure, you ll no longer have a house payment, which may bring you comfort, but you ll also be giving up access to ready liquidity and any tax deductions you take on the interest. Instead, you may want to continue your payments, or refinance for a lower interest rate and smaller payments, then use the extra money to pay down higher cost debt, save toward higher priority goals like retirement or college tuition, or leave the money in the portfolio to attempt to capitalize on market gains. This makes especially good sense if you think the markets can generate a greater after-tax return than what you re paying on the mortgage. Your comfort level Debt can be a powerful tool that allows you to use capital in other ways, thus helping you achieve your goals faster than saving might. After the recession, it s understandable that people hesitate to take on debt and prefer to keep cash on hand. However, in many cases, borrowing wisely may have a place in your overall financial strategy. The key is finding the right balance for you and your family. Just remember to seek options with low interest rates and avoid penalties and fees. Remember, too, that taking on some debt is a financial decision, one made easier with a little help from knowledgeable professionals. Does debt die? What happens to debt after a person passes away can be complicated. The rules vary based on the type of debt, but credit card debt can be inherited by spouses, both widows and exes, and even adult children, especially if you re joint cardholders. After a loved one s death, the estate will pay debts to creditors before beneficiaries can receive their inheritance. But you could still be on the hook if there aren t enough assets to cover the debt. Creditors have a specific time period to file a claim and are prioritized by secured (e.g., mortgages and car loans) and unsecured debt (e.g., credit cards). The estate pays in order of priority, and credit card companies tend to be at the back of the line. But that may not stop them from contacting you to recoup their losses. It s a good idea to consult an attorney with specific knowledge of the debt laws in your state before the estate pays anything. Choosing the right lending program is as much a part of the financial planning equation as saving and investing Margin or a securities-based line of credit may not be suitable for all clients. Borrowing on securities-based lending products and using securities as collateral may involve a high degree of risk. Market conditions can magnify any potential for loss. If the market turns against the client, he or she may be required to deposit additional securities and/or cash in the account(s) or pay down the loan. The securities in the pledged account(s) may be sold to meet the margin call, and the firm can sell the client s securities without contacting them. The interest rates charged for a securities-based line of credit are determined by the market value of pledged assets and Capital Access. The interest rates charged for margin are determined by the amount borrowed. For additional information on margin, visit http://sec.gov/investor/pubs/margin.htm. The proceeds from a securities-based line of credit cannot be used to purchase or carry margin securities. Securities-based line of credit provided by Raymond James Bank. Raymond James & Associates, Inc. and Raymond James Financial Services, Inc. are affiliated with Raymond James Bank, N.A., member FDIC. 2013 Raymond James & Associates, Inc., member New York Stock Exchange/SIPC 2013 Raymond James Financial Services, Inc., member FINRA/SIPC Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value. 12-FA-WW-0120 EK 6/13