Is it a good idea to have debt, even if I can afford not to?

Debt typically isn’t a necessity for wealthy individuals and families. But it can be a tool. Some use debt to mitigate taxes. Some take on debt to gain liquidity. Others use debt as leverage to help grow their balance sheet, albeit with an added risk.

But achieving the right balance can be difficult. Should you strive to be debt-free? Or are you not taking enough advantage of debt in pursuit of your financial goals? As is often the case, the answer is ‘it depends.’ But there are some general pros and cons of debt that you should factor into your decision-making.

Eliminate bad debt

The first step in determining what place debt might have in your balance sheet is to isolate your “bad” debt. This typically involves high-interest debt, like credit cards, auto loans and in some cases student-loan debt.

Your goal should be to pay off these debts as soon as you can. Once you have the funds, any advantage of carrying these debts will not outweigh the costs of paying high interest rates on these loans.

Identify risky debt

Along with eliminating your bad debt, you should identify your risky debt. Most debt comes in one of two varieties:

• Fixed-rate loans where the interest rate does not change and the loan is typically paid back on a set schedule over a pre-determined period (e.g., a 30-year mortgage).
• Variable-rate loans where the interest rate fluctuates and the payoff schedule may be uncertain too (e.g., a 5-year ARM or adjustable-rate mortgage).

Variable-rate loans often have lower initial rates, but that comes with a layer of risk, as your rate may go up over time.

It is important to think through what you would do if your interest rate increases. You may think you would refinance whenever it rises, but at that point it’s likely too late for that to be your answer.

When you consider refinancing, it’s important to weigh all the factors. These include current interest rates, potential future rates, the costs to refinance and your ability to consolidate different loans. Also consider your personal circumstances. If you anticipate moving or a change in financial status that could leave you needing to refinance or take out a new loan in the near future, you may want to postpone refinancing to avoid the costs of doing it twice.

Determining your debt vs income ratio

Standard debt ratios are another way to identify if you have too much debt. Here, your risk is having more debt than you can manage, along with the stress that brings to your finances and life. In more expensive regions, a reasonable ratio can be hard to maintain even for high earners; yet, it still can provide useful perspective. These are general ratios to consider as you evaluate your debt:

• Housing debt costs (principal + interest + taxes + insurance): should be no more than 28% of your gross income (monthly)
• Housing costs plus all other recurring debt (such as auto loans, student loans or similar longer-term debt): should be no more than 36% of your gross income (monthly)

Using debt to manage taxes and liquidity

Separate from bad debt, there can be situations where debt can help you achieve your financial goals. If you’ve been taught that debt is something to avoid, it can be difficult to appreciate the opportunities to use debt strategically to enhance your financial picture.

For example, let’s say you’ve built enough wealth that you can afford to buy a $1 million home with cash. Alternatively, you could make a 20% down payment and take out a mortgage for the balance. A mortgage could provide you with several benefits:

• Avoid capital gains. If your $1 million is currently invested, the mortgage avoids the need to liquidate your portfolio. This could avoid capital gains taxes.
• Mortgage interest deduction. Under current tax rules, you can deduct the interest you pay on home mortgage debt with balances up to $750,000. The interest deduction effectively decreases your interest expense by lowering your income taxes.
• Interest tracing deduction. If you borrow more than $750,000, you still might be able to deduct the interest on the amount above $750,000 if you apply and can trace the loan proceeds to a different investment (see more detailed description below).
• Maintain liquidity. By not using your liquidity to buy the home, your portfolio will still be available to meet other cash needs.
• Larger portfolio. When you borrow, your net worth is the same on day one. But if your investments appreciate, your balance sheet has potential to grow at a larger rate. For example, if you retain a $800,000 portfolio after buying the house and both values grow by 10%, that’s $80,000 of extra value you would not have had if you bought the house with cash. Of course, if your assets depreciate, your balance sheet also shrinks at a quicker rate. If the value of your home and portfolio both went down by 10%, your net worth would go down by 18% since your debt doesn’t decrease when your assets lose value.

What is interest tracing?

In addition to the mortgage interest deduction, current tax rules allow you to deduct “investment interest,” up to the amount of your net investment income. The key to whether your interest payments qualify as “investment interest” is how you use the loan. If you can trace your loan proceeds to investment property, such as marketable securities or investment real estate, you may be able to deduct the interest, even if your loan is secured by other property. Loan proceeds are deemed to apply to an investment if it’s made within 30 days before or after being deposited into the account used to make the investment. Changes in your investment can both enable and disallow your deduction.

Borrowing as a wealth transfer strategy

Finally, debt can play a role in your estate plan and wealth transfer strategy.

Let’s say your main asset is stock in a company that has grown in value substantially. If you can avoid selling the stock during your lifetime, it’s possible neither you nor your heirs will need to pay income taxes on any of that appreciation. How? Because capital gains that have built up during your lifetime disappear when you die. Due to the “step-up” in income tax basis at death, your heirs can sell your assets without any gains.

For some families, the costs of borrowing against a portfolio versus selling it can be worth it, if you are potentially avoiding capital gains entirely via the “step up.”

Borrowing and lending also can be an efficient means of passing assets to the next generation for estate taxes. When the older generation lends money to the younger generation (or trusts for their benefit), it typically leaves the older generation holding a promissory note that can put a freeze on the value of their estate. Meanwhile, growth assets can be placed in the hands of the future generations.

Discover how debt may fit your financial strategy

Debt is another tool in your financial toolbox that may offer benefits, depending on your goals and financial situation. While you may view debt as something to avoid, our wealth advisors can help you determine how it might work in your favor if applied effectively.