As a financial advisor, I continually get asked by my clients if they should borrow money for certain things such as buying a home, open lines of credit for a business or pay off consumer debts such as credit cards and car loans.
The fundamental principle in borrowing money is that the interest and other costs of obtaining the loan are less than the value that is created by borrowing the money. As an example, if one borrows money at 4% and creates a 7% return, all else being equal, then there is a 3% profit or “positive arbitrage” return on that investment. The goal is to get the greatest rate of return with the lowest cost so profits are maximized.
Assets such as houses and businesses can be used as collateral to secure a loan. One can also use a consumer asset such as a car or his signature, as in a credit card.
But when should one borrow and when should debts be paid off ASAP?
Well, there are three factors that determine when a person should borrow money. They are income, appreciation, and tax benefits.
1. Income – Money should really be only borrowed against assets that produce an income. Commercial and investment real estate and other business operations produce income since the asset is used in business to provide a valuable service to another for money. This income can then be used to service the debt owed on the asset. Personal assets such as primary residences, cars, and personal lines of credit do not produce income.
2. Appreciation – One may borrow money against assets that would, over the long-term, appreciate in value. Even if the income for the use of the asset did not provide enough income to pay off the debt, the eventual sale of the asset would be at a higher value in the future so the debt could be retired upon sale. Commercial and investment real estate have the potential for appreciation as well as businesses as they grow in value through expansion. Primary residences may or may not appreciate in value, depending on the market and holding period. Consumable assets such as cars, boats, and personal credit lines do not appreciate but decline in value.
3. Tax Benefits – The government will pass laws that allow certain types of indebtedness to have preferential treatment in the tax code. When you borrow money for business purposes, the interest and other costs associated with the loan may be tax-deductible. Since you are receiving a rebate on the taxes you would otherwise owe, your cost to borrow the money is less. This creates an even larger gap between the borrowing cost and the value realized from putting those assets to productive use.
Another tax benefit may be in the form of depreciation. An asset purchased for business use is assumed to decline in market value over a certain period of time. The tax law allows a taxpayer to claim each year’s depreciation of the value of the asset against other income. This also has the effect of lowering the cost of borrowing.
When you are determining whether to borrow or not, you will have the greatest chance of profit if ALL 3 factors exist in the borrowing decision. This would only include borrowing for business purposes such as commercial or investment real estate and business debt. If you have 2 or 1 out of the 3 factors, pay it off quickly.
It is a common belief among financial advisors that a person should have a mortgage against their primary residence. Of course, this would be necessary to get into a home that could not be paid for with cash. But once the home is acquired, it would be proper to pay the home off as soon as possible rather than having perpetual debt against the property.
Why? Look at the 3 factors. A home does not provide income (unless you have a business property that has a dual purpose) and may or may not appreciate over the money you’ve poured into it. It does have the advantage of tax-deductible interest costs, however, but no depreciation benefits.
We have all heard that our home is our single largest investment. Is it? From who’s point of view? That is true, only from the perspective of the lender that utilizes the house as security for a loan. To the homeowner, it is a liability. It costs money for maintenance and improvements each year and is simply a place to live. On average, its value will keep pace with the actual rate of inflation (which is higher than “official” figures).
Intelligent borrowing means to borrow the money at the lowest net cost and generate the greatest value possible with the proceeds. Business applications give the best potential while personal indebtedness has the highest risk of not achieving the desired results.
When faced with a decision to borrow or not to borrow, remember these 3 factors and you will be fine.