At what interest rate should debt be used as a tool?

Question

I know people love to preach the merits of being 100% debt-free, but when used intelligently, debt can be a powerful tool. All else equal, if I have debt at an interest rate of say 1% and have an instrument that returns 3%, that 2% gap is profit (I know for a variety of reasons (taxes, etc.) it's not that simple, but you get the point).

That said, it's usually not as simple as that. Many investment instruments carry a fair amount of uncertainty around their expected return, and the utility of a dollar lost might not equal the utility of a dollar gained. What guidelines do you use to determine the interest rate where it makes sense to keep the debt and invest rather than eliminating the debt?

Answer 1

I've been taking all the cheap fixed-rate debt banks would like to give me lately.

What Rate?

In practice I find the only way I get a low-enough rate on a longish-term fixed-rate loan is to use collateral. That is, auto loans and home loans. I haven't seen any personal loans with a low enough fixed rate. (Student loans may be cheap enough if they're subsidized, I guess.)

Here's how I think of the rate:

If you look at https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations , the average annual return on 80% bonds / 20% stocks is 6.7%, with worst year -10.3%. That's a nominal return not a real return. If you subtract taxes, say your marginal rate (the rate you pay on your last dollar of income) is 28% federal plus 5% state, then if you have no tax deferral the 6.7% becomes about a 4.5% average, with reasonably wide variation year-by-year.

(You can mess with this, e.g. using tax-exempt bonds and tax-efficient stock funds, etc. which would be wise, but for deciding whether to take out debt, getting too detailed is false precision. The 6.7% number is only an average to begin with, not a guarantee.)

Say you pay 4.5% on a loan, and you keep your money in very conservative investments, that's probably at least going to break even if you give it some years. It certainly can and sometimes will fail to break even over some time periods, but the risk of outright catastrophe is low. If your annual loss is 10%, that sucks, but it should not ruin your life.

In practice, I got a home loan for close to 4.5% which is tax-deductible so a lower effective rate, and got an auto loan subsidized by the manufacturer for under 3%. Both are long-term fixed-rate loans with collateral. So I was happy to borrow this money paying about a 3% effective rate in both cases, well below my rough threshold of 4.5%.

I do not, however, run a credit card balance; even though one of my cards is only 7% right now, 7% is too high, and it's a floating rate that could rise. The personal loans I've seen have too-high rates also.

Thoughts

• One of the reasons I take the loans is liquidity. If I have $N in cash and then owe relatively small payments over 6 years, then that is a lot more flexible than not having cash and owning a car. If not having cash and owning the car outright ever becomes desirable, then pay off the loan, and be in that situation overnight. The other direction is often impossible.
• Another reason I take the loans is that it makes budgeting easier. I like to think of major assets (house, car, etc.) in terms of monthly cost. Then you can see how much more you need per year (and how much more you have to save for retirement) if you spend a certain amount on the car. Of course if you pay cash you can still compute the monthly cost, but it's just a little easier if it's actually a monthly cost, in my opinion.
• If you need a credit history, getting a loan can give you one, though a credit card is probably a simpler way.
• I have a fair amount of "wiggle room" (solid emergency fund, no trouble covering the debt payments). The more trouble you'll have with the payments, the less you should be buying anything at all probably, let alone with debt.
• You probably shouldn't be considering your emergency fund in this calculation. That is, don't consider using the emergency fund instead of getting the loan, and don't consider putting the emergency fund in anything higher yield than cash.
• Borrowing money at a low rate puts you in a good place if interest rates rise (or, probably saying the same thing, if inflation increases).
• Borrowing money (even at a low rate) would be bad if we get deflation. Thankfully that hasn't happened in general since the Depression, but it is happening now in housing specifically, and I'm sure you've seen on the news how it's bad for those who borrowed money to buy.
• Borrowing money at a floating rate is a risky idea. You lose in both inflation and deflation scenarios.
• I'm not sure the pay-cash-or-get-the-loan decision is all that important in the scheme of things. It isn't likely to be make-or-break on your overall financial situation. So you may as well do what makes you feel comfortable. For me, extra flexibility makes me comfortable, but for others, debt makes them uncomfortable. Both are valid.
• My discussion here assumes you have the option to pay cash. If you couldn't pay cash, you have nothing to invest, and no cash to keep in order to increase flexibility.

Overall I think using debt as a tool requires that you're already financially stable, such that the debt isn't creating a risky situation. The debt should be used to increase liquidity and flexibility and perhaps boost investment returns a bit.

Where you're likely to get into trouble is using debt to increase your purchasing power, especially if you use debt to buy things that aren't necessary.

For me the primary reason to use debt is flexibility and liquidity, and the secondary "bonus" reason is a possible spread between the debt rate and investment returns.

Answer 2

Money is a commodity like any other, and loans are a way to "buy" money. Like any other financial decision, you need to weigh the costs against the benefits.

To me, I'm happy to take advantage of a 0% for six months or a modest 5-6% rate to make "capital" purchases of stuff, especially for major purchases. For example, I took out a 5.5% loan to put a roof on my home a few years ago, although I had the money to make the purchase.

Why did I borrow? Selling assets to buy the roof would require me to sell investments, pay taxes and spend a bunch of time computing them.

I don't believe in borrowing money to invest, as I don't have enough borrowing capacity for it to me worth the risk. Feels too much like gambling vs. investing from my point of view.

Answer 3

Average return on the S&P500 over the last 10 years has been 1.6 %; so if you'd invested in that with money borrowed at 3 % you would have lost (so far).

Investing with borrowed money implies you think you can beat the market: that you're a cleverer investor than whoever decided to lend you the money.

Whoever decided to lend you the money decided that you are the best (return/risk ratio) investment for their money.

It might make sense to invest borrowed money if you don't need to pay it back if things go wrong: if you're an investment professional whose bonus depends on the profit you make, but who won't need to repay any loss.

It might also makes sense to borrow money if you're going to 'add value', e.g. sweat equity: for example if you use it to renovate a house or (if you're a business) to hire more staff. But the question was "What guidelines do you use" and the answer is, "I don't make passive investments with borrowed money."

My Dad did it, i.e. didn't repay his mortgage as soon as he could have: but that was because (back in the '70s) he had a long-term (government-sponsored) mortgage for about 1.5 % (designed to help first-time buyers or something like that), at a time when banks were paying higher interest rates on (ultra-safe) deposits.

Answer 4

This is a very interesting question. I'm going to attempt to answer it.

1. Use debt to leverage investment. Historically, stock markets have returned 10% p.a., so today when interest rates are very low, and depending on which country you live in, you could theoretically borrow money at a very low interest rate and earn 10% p.a., pocketing the difference. This can be done through an ETF, mutual funds and other investment instruments.

2. Make sure you have enough cash flow to cover the interest payments! Similar to the concept of acid ratio for companies, you should have slightly more than enough liquid funds to meet the monthly payments.

3. Naturally, this strategy only works when interest rates are low. After that, you'll have to think of other ideas. However, IMO the Fed seems to be heading towards QE3 so we might be seeing a prolonged period of low interest rates, so borrowing seems like a sensible option now. Since the movements of interest rates are political in nature, monitoring this should be quite simple.

4. It depends on you. Since interest rates are the opportunity cost of spending money, the lower the interest rates, the lower the opportunity costs of using money now and repaying it later. Interest rates are a market mechanism so that people who prefer to spend later can lend to people who prefer to spend now for the price of interest.

*Disclaimer: Historically stocks have returned 10% p.a., but that doesn't mean this trend will continue indefinitely as we have seen fixed income outperform stocks in the recent past.

Answer 5

It's not so much the rate of the debt as it is the total cost of the debt relative to the gain you expect to see from using it to purchase something of value.

I've known people who were quite happy to pay 12% on personal loans used to buy investment properties for flipping. They're happy to pay that because conventional loans from banks require too much documentation and out-of-pocket expense. For some investors, 12% without all of the documentation burden is money well spent.

So if I'm the investor, and the interest on this 12% loan is $5,000 and I can flip a property for $20,000 after all of the other expenses, then the 12% loan was an enabler to netting $15,000 profit.

Answer 6

This post has a great discussion on the topic.

Basically, there is no single interest rate above which you should pay off and below which you should keep. You have to keep in mind factors such as

• Whether or not the interest for that debt is tax deductable.
• What is the expected return of the alternative investment option.

Answer 7

It's tough to borrow fixed and invest risk free. That said, there are still some interesting investment opportunities. A 4% loan will cost you 3% or less after tax, and the DVY (Dow high yielders) is at 3.36% but at a 15% favored rate, you net 2.76% if my math is right. So for .5%, you get the fruits of the potential rise in dividends as well as any cap gains. Is this failsafe? No. But I believe that long term, say 10 years or more, the risk is minimal.

Answer 8

I don't really see it as worth it at any level because of the risk.

If you take $10,000,000 using the ratios you gave making 2% return. That is a profit of $200,000. Definitely not worth it, but lets go to 20% profit that is $2,000,000. To me the risk involved at beint 10 million in debt isn't worth it to make $2,000,000 quickly it would be pretty easy doing something wrong to wipe out everything.