Debt: A Four Letter Word?

The word “debt” often carries negative associations.

Leverage (debt), combined with greed, brought the global economy to its knees in 2008, destroying value and causing great hardship for so many people around the world. However, debt is not always bad. With careful consideration and the help of a trusted adviser, borrowing money to enable one to accomplish positive things that would otherwise not be possible can be a good decision. Below we provide some thoughts on good types of debt, bad types of debt, and Howland Capital’s core beliefs on the sometimes taboo topic of debt.

Howland Capital’s Five Core Beliefs When It Comes to Debt

1. Debt is not always bad. There is good debt, and there is bad debt. There is also a gray area. Borrowing money to fund a life need can be a great idea. It can also result in stress, financial strain, and undesirable consequences. Seeking the help of a trusted adviser is a good idea if you are unsure about borrowing money to fund a purchase, for example.
2. Only borrow what you are confident you will be able to pay back over time. Before signing the documents and spending borrowed money, it is a good idea to do some financial planning. Sometimes a lender will tell you that you can afford to borrow more than you really can. We saw this repeatedly in the years just before the 2008 financial crisis. Building confidence in a plan to repay debt will help ensure the borrowings serve to positively impact your life and reduce the associated stress.
3. It can be helpful to look at debt as an investment. The goal of an investment is to earn a return on the principal invested. The “return” you get from spending borrowed money should exceed the “cost” (i.e., interest rate) you pay to borrow the money. Whether borrowing to buy a house, earn an advanced degree, or purchase a car to get to work, borrowing money to position yourself for greater future success can be a sound, rational act. If the “return” you can achieve using borrowed money is not clear, seeking the help of a trusted adviser on this question can make a big difference.
4. Scenario planning can help you make the best decisions. You should always consider your risk tolerance, potential to repay debt under different life scenarios, and trade-offs (“opportunity cost”) to taking out debt. It is better to consider such factors upfront.
5. Different types of debt come with different types and levels of risk. Borrowing money to buy a house, especially with interest rates still so low, is generally a lower-risk endeavor. This is especially the case if your earnings are stable and more than sufficient to cover the cost of a mortgage. Borrowing money to start a business could be much riskier. Having a rainy day fund, or emergency savings, can help offset the risks associated with debt. At the far end of the spectrum, borrowing money to fund a lifestyle beyond your means is very risky and should be avoided.

Examples of Good Debt

• Taking out a mortgage to buy a home. Mortgage debt can be a good idea for many reasons. First, interest rates are at historic lows. Second, interest payments on a mortgage might be tax deductible (NOTE: it is always a good idea to speak with a tax professional before making a decision based on taxes). Third, why pay someone else’s mortgage (via rent) when you can pay your own? Furthermore, most mortgage payments include both interest as well as principal payments. In other words, every month you pay principal, thus reducing the size of the outstanding debt. In effect, paying principal is a forced way of saving money, building wealth, and increasing the equity you have in your house. While buying a house can be a great idea, it is always important to consider local economy dynamics in the area where the house is located. As with all investments, home values can go down and mortgage holders can lose money.
• Borrowing money to fund an education. Student loans often carry a negative connotation in the press, but they can be a valuable tool. Consider this: you graduated from college and got a good job paying $50,000 per year. You decide to pursue a graduate degree (medical school, law school, business school, etc.) with the expectation of making $150,000 when you graduate. Let’s say you don’t have any savings and the advanced degree will cost you $300,000 total. The “return” you earn on the $300,000 you “spend” on school is $100,000 per year, or 33% (before taxes). If the interest rate on the student loan debt is 5%, you made out well! You borrowed at 5% but invested the borrowings to earn 33%! What a great investment! NOTE: the math above is overly simplified for the purpose of making a point. It is always a good idea to speak to a trusted adviser before making big decisions involving debt.
• Borrowing money to buy a car, within reason. Let’s say you landed your dream job but you need a car to get to work. Without transportation, you cannot take the job. Borrowing money to buy a car would be a good choice because the earnings available to you are likely more than enough to offset the added cost of a car loan. However, careful selection of a car is important. Having an expensive luxury car can be tempting, but you should still do the math on the return.
• Consolidating your debt. Life happens, people make mistakes, and it is very common to end up in a situation with too much debt from too many sources. Debt can quickly make life feel overwhelming, and when creditors are calling and sending scary letters, this can only compound the effects. It can be a good idea to consolidate debt in order to take control, reduce payments to a manageable level, and stop all of the phone calls and letters.
• Taking out a home equity line of credit. A home equity line of credit (HELOC) can be a great way to use a home’s value to have funds available for unforeseen needs. You only pay based on funds you actually borrow, so having an untapped line of credit can provide peace of mind in the event the money is needed.
• Taking out a security backed line of credit. A security backed line of credit (SBLOC) can enable you to make a purchase or finance an education without having to sell appreciated securities (and therefore incur capital gains taxes). These types of loans are not for everyone, however. It is best to speak with a trusted adviser to learn more.
• Taking out a small business loan. Do you have a great idea for a business and a carefully constructed business plan, but not enough funds (or you do not want to put all of your savings into it)? Borrowing money to start a business can provide you with the opportunity to get up and running without having to give ownership (“equity”) to someone else. These loans can also be quite risky depending on the type of business involved.

Examples of Bad Debt

• Borrowing money where the interest rate exceeds the “return” you get on the borrowed money. As stated above, with the help of a trusted adviser, you can create various outcomes based on various scenarios. If the majority of outcomes point to a lower expected return, it is best to re-think your plans.
• Keeping credit card debt. Rates lenders charge on credit card loans are extreme, often reaching 15-20%. Furthermore, most credit card purchases are for things that lose value upon purchase.
• Borrowing money to live beyond your means. It is generally a bad idea to borrow money in order to spend more than you earn.
• Taking out a payday loan. Payday loans, which lenders extend to tide you over until your next paycheck, are typically predatory. Many payday lenders charge $15 per $100 (or 15%) to make payday loans, which often carry a two week term. 15% for two weeks is equivalent to an annual interest rate of nearly 400%!

Background on Howland Capital: Howland Capital is an independent registered investment adviser offering a customized approach to wealth management for individuals, families, foundations, and institutions. Our team is focused on the long term to ensure that wealth acts as a positive influence in our clients’ lives. We are committed to remaining independent in order to provide the stability and continuity that our clients deserve.

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