Strategic borrowing can keep your financial plan intact and at work.

Truths that seem universal often fray at the edges, particularly when talking about money.

Take for example the popular and often helpful advice from writers of bestselling personal finance books. One common tenet is to aggressively pay down debt and then live without it. This is great advice for many, but not everyone, highlighting how our unique situations make a major difference. To that point:  

• For spenders, people who have difficulty delaying gratification, this advice can be a useful and rewarding core discipline. Extreme spenders easily fall into credit card debt traps that drag on their financial situations.
• For those on the extreme saver side of the spectrum, this advice can instead cost potential opportunities. Not all debt is made of the same stuff, and risk should be thoughtfully explored before committing to major financial strategies.
• For those with stratospheric net worth, paying down debt immediately could prevent them from using strategies that keep their assets intact and able to grow while providing liquidity – simple income or the flexibility to react to potential investment opportunities. For them, debt is often an inexpensive way to manage access to cash.

And even for people who may not be able to leverage a Dali painting hanging in their foyers, debt can be a useful tool to keep their wealth engines running if it comes cheaply enough relative to other opportunities, keeps their assets working for them and, above all, if the risks are understood and tolerable. And that’s the key. Truly understanding if debt can help you take a balanced approach to liquidity without disrupting your investment or retirement plans or your lifestyle. 

This is where your financial plan – one tailored to your unique circumstances, including assets and liabilities – can open up a world of opportunity.

Examining the details

A simple quiz illustrates what we mean:

You are a responsible, financially comfortable investor who has just inherited $100,000. Your goal is to maximize the benefit. For instructive purposes, let’s ignore the uncertainties of the market and the complexities of taxes. What should you do with it?

A) You pay off the $100,000 balance on your mortgage, which has a 3% fixed interest rate.

B) You invest it into your portfolio, which hypothetically averages 6% gains each year.*

C) You create a rainy-day fund in a savings account earning negligible interest.

In a world without risk, the clear answer is B: Your portfolio has an open-ended invitation to compound onto itself. As for the other options, the mortgage has a known, fixed cost that isn’t particularly egregious. Paying it off early may be an emotionally fulfilling accomplishment, but it potentially comes at a major opportunity cost. And a savings account would currently erode in the headwinds of inflation.

There can be a strong case to make for Option A for many investors, particularly ahead of retirement. For established investors, Option C might not be an ideal answer except to manage specific risks – and there are other options for maintaining cash on hand that we’re about to explore.

*This hypothetical example is not indicative of any security’s performance. Expenses have not been included in the example and will affect performance. 

Investment income without capital gains

A topical question these days is how the nation’s wealthiest individuals pay relatively little in tax in comparison to their fortunes. The short answer is that they don’t take a traditional income and most of their wealth is in highly appreciated assets – like shares in the company they founded. They don’t need to sell stocks, which would trigger capital gains taxes. Instead, they can take loans against their shares.

Securities based lending, securities based lines of credit, home equity lines of credit and structured lending are options for leveraging assets without selling them. These loans tend to have relatively low interest rates because they are collateralized. There is a major caveat, however: If the value of the underlying stocks, bonds or other assets no longer meet the value of the outstanding loan, the bank will request additional securities as collateral – or start selling. That means a market downturn can create some additional challenges.

At the intersection of taxes, investments, family budgets, surprises and everything else, figuring out when it’s best to strategically borrow or when to just pay cash can be a complicated question. Luckily, this isn’t a unique question, and your financial advisor may have tools to help. 

Sources: The Wall Street Journal; forbes.com; advisorhub.com; fool.com; marketwatch.com

These lending products may not be suitable for all clients. They may involve a high degree of risk, including unintended tax consequences and the possible need to sell your holdings, which may lead to a significant impact on long-term investment goals. Market conditions can magnify any potential for loss. If the market turns against the client, he or she may be required to quickly deposit additional securities and/or cash in the account(s) or pay down the loan to avoid liquidation. Further information is available from your financial advisor.