In the strictest sense of the words, there is no difference between debt and leverage. They both borrow something from your future in exchange for “benefits” today. The interest rate environment is at a historic low, tempting people to use leverage by taking cash or equity out of their houses. Should you or shouldn’t you and how do you decide?
Individuals utilize debt to acquire things they need today – or at least think they need. New cars, appliances, and furniture are some of the standard purchases. You get the comfy couch today in exchange for payments in the future. Interest rates slow purchasing down because you pay back what you borrowed plus the bank fees.
Companies tend to take on debt to finance operations and surprisingly, often to refinance existing debt. That makes sense when you can pay off obligations at 5-6% and refinance them for 4% of less. The key takeaway is that they are exchanging future choices by current decisions. That is true of all leverage. When you borrow from your future, you also limit options in the future.
Which debt should you pay down and which debt should you keep? That is a decision only you can make. The options are limited by what current resources you have today to pay down debt and your investment tolerance.
Two weeks ago, on my radio program “Consider This Program”, I mentioned we should pay down any and all debt above 4.5%. The questions came quickly! Why 4.5%? Three factors came into the equation for our family and they do the same for yours.
First is investment allocation. This includes your 401k or retirement accounts. We are never fully invested in stocks, bonds or cash and maintain a reasonable allocation in each. Reasonable of course is in the eye of the beholder. If I had debt with interest rates above 4.5% and I didn’t believe my bonds would earn 4.5% or more, why wouldn’t I pay down the debt? Why would I keep money in bonds?
The second issue is having the resources to pay down debt. This can come from using other assets – like the equity in your home – or current cash flow. For the record, just because you can take money out of your house doesn’t mean you should. That is a deeply personal and important decision.
The third issue is one of “netting” out the opportunities. If I borrow today to buy something – car, lake house, dream vacation – I limit my choices tomorrow. The same is true of pulling equity out of my house. There may be a nicer opportunity, but saying “yes” today means saying “no” then.
Determine how much risk you are willing to take in the investment world. If you only own CD’s, don’t even think about using home equity. If you are all stock driven and have a long enough time horizon, then you may want to consider the option. Proceed with caution but make certain you understand the choices you make today impact your future.
Disclaimer: Joseph Clark is a Certified Financial Planner™ and the Managing Partner of Financial Enhancement Group, LLC an SEC Registered Investment Advisor. He is the host of “Consider This” found on WIBC Saturday mornings from 6-7a.m. as well as three other Indiana-based radio stations. Joe has served as an Adjunct Assistant Professor at Purdue University where he taught the capstone course for a degree in Financial Counseling and Planning.
Financial Enhancement Group is an SEC Registered Investment Advisor. Securities offered through World Equity Group, Inc., Member FINRA/SIPC, and a Registered Investment Advisor. Investment Advisory services offered through Financial Enhancement Group (FEG) or World Equity Group. FEG is not owned or controlled by World Equity Group.
Joseph Clark and World Equity Group, Inc. do not provide tax or legal advice. For tax advice consult with a qualified tax professional. For legal advice consult with an attorney.