One of the most common financial questions we receive at The Financial Consulate is, “When is it best to borrow money versus using existing savings?” Oftentimes those in the business of providing financial advice will recommend borrowing money whenever you can get a relatively low interest rate. Unfortunately, people may not be aware that this advice may come with something we refer to as an “economic bias.” Think about it from the advisor’s perspective…borrowing new money rather than using your existing savings will allow for the balance in your investment account (and the fee or commission that your advisor is charging on that balance) to remain the same. We prefer to address the borrowing issue by posing two questions to the client…“What are your goals” and “What are your personal economics of borrowing?”
My own professional bias is to see my clients be debt free. The human spirit longs to live without debt. Debt is one of the chains that hinder us from the path of fulfillment in life. Debt can easily keep us in an employment situation we no longer enjoy, simply because we have to “pay the bills.” Credit can give us an illusion of being free as we wield our credit cards for the things we want – until the bill comes in.
When used wisely, debt can be your ally. When used foolishly, it can lead to bankruptcy. When considering debt the most important thing is to understand what you NEED. We think we need coffee, we need new clothes, we need a new car, and we need to go out to dinner. It is imperative, especially when young, that we maintain an understanding of the difference between what is a NEED and what is a WANT.
Let’s look at the economic side of the debt issue. Too often people are fooled by looking at debt from only one angle, like the fact that if something is tax deductible it automatically makes it good. Nothing could be further from the truth. Tax deductibility of some types of interest is only a small part of the equation. A new car loan at 3-percent is not tax deductible, but a Home Equity Line of Credit (HELOC) at 3-percent is likely to be deductible. Does that mean the HELOC is the better route for a new car purchase? Not necessarily. One must consider the car loan is fixed and the HELOC is variable and that a car loan is repaid in three to five years and a HELOC allows you to amortize or just pay interest. Tax deductibility is a piece for sure, but a fixed rate is safer. A credit line is a source of emergency cash and an amortized loan forces us to pay the loan off.
In the last five years the Federal Reserve has driven the interest rate of mortgages down to a slim margin over the rate of inflation. This phenomenon created an opportunity to borrow at ridiculously low interest rates locked in for 15 to 30-years. The 15-year loan clearly reduces the interest paid over the life of the loan (which is a good thing), but what if you took that extra cash flow and saved it in your company’s retirement plan (e.g., a 401(k) or 403(b) plan) instead? Many times a good income earner who longs to be debt free before their ultimate retirement date will minimize their retirement plan contributions to pay more on their mortgage so that they are debt free in a shorter period of time. A 15-year, $200,000 mortgage at 4-percent will cost approximately $1,480/month and a 30-year mortgage will cost approximately $980/month at 4.25-percent (rates are higher on 30 year mortgages). What if instead of paying the mortgage off faster you saved the additional $500/month (or more due to the tax benefits of the 401(k)/403(b) contributions being pre-tax) in your company sponsored retirement plan? Many retirees that want to be debt free in retirement sell their homes (which may not be paid off) and move to less expensive, smaller homes which they can purchase without utilizing a mortgage. Which method is better depends on your goals and objectives – your personal economics.
Debt elimination is a good goal, but it is not perfect in every situation. Create your personal financial goals, analyze your personal economics, and then develop a plan to maximize your odds of accomplishing your goals. Debt can be both an ally and an enemy. You can be assured it is an ally when you use it thoughtfully and conservatively.
Ryan Fox is the Gettysburg Director for the Financial Consulate, Inc. located at 131 Carlisle Street in Gettysburg. He can be reached at 717-334-1861, at firstname.lastname@example.org, or through financialconsulate.com/ryan-fox/. The Consulate is a fee only, NAPFA member financial advisory firm with salaried employees who accept no commissions.