Leveraging Your Debts

Andrew Busa:

Debt is a powerful tool to leverage as part of your financial plan. Listen to this podcast to get our thoughts on how to make sure you’re taking full advantage. Hello, this is Andrew Busa and I am the Manager of Financial Planning here at Adviser Investments. And we’re here with another The Adviser You Can Talk To Podcast. Today, I am excited to be joined by my colleague, Mike Dillaire. Welcome back.

Mike Dillaire:

Hey, Andrew. Happy to be here.

Andrew Busa:

Absolutely. It’s good to have you back for another episode. In our previous episode together, titled Keeping Credit on Your Side, we primarily focused on credit cards and really understanding your credit score, kind of laying the foundation for folks to understand just what debt is, how to use it. And we teased this as a follow up episode, where we’ll talk about other forms of loans that are affected by your credit score. So drum roll, please. That is what we’re talking about today.

Mike Dillaire:

Did not see that coming. So what did you want to cover today?

Andrew Busa:

We’ll focus on three broad stages of financial planning and how debt fits into them. So as we think about it here, the accumulation phase, pre-retirement, and then, finally, in retirement. And specifically, within those three phases, there are, of course, different types of financial goals to plan for. And debt, when used the right way, will help you accomplish those goals.

Within those phases, we’ll be covering how to approach debt with a first-time home purchase, a second home purchase, and then, also some loans to think about when you already own your homes and you’re just looking to leverage that equity. So of course, mortgages here will be a hot topic, but we’ll also spend some time talking about other types of loans to be aware of, like portfolio lines of credit, home equity loans, maybe even some time on reverse mortgages, if we have time.

And we’ll do a quick lightning round on other kinds of loans that don’t fit neatly into one of these boxes. Mike, your expertise will be very valuable in this episode.

Let’s start with that accumulation phase that we mentioned in the introduction. Thinking about setting the stage here, and we help the clients with this all the time, buying your first home, how to approach that, and how to really think about the mortgage aspect of this, because let’s face it, this is the largest purchase that most of us will make in our lives. So we want to make sure that we’re getting this right.

Mike Dillaire:

Yeah, absolutely. For the accumulation phase, we’re thinking buying first home. So we’re thinking mortgages. So fixed mortgages are the most commonly used type of loan. You are given an interest rate through the lender, which is locked for the duration of the loan. I’d say nine out of 10 people probably go with the 30-year fixed mortgage when buying a home. It’s the longest loan. So usually cheaper payments, because they’re spread out over the longer. And you can take a tax deduction on the interest paid on your mortgage. Often, we see people choose a different situation, such as like a 15-year fixed if they’re refinancing. Hypothetically, if someone is 20 years into their original 30 year fixed and refinancing to a 15 year, for example, where refinancing essentially is trading in your old loan for a new one. People often do this to extend time or to lower their interest rate.

Andrew Busa:

Yeah, and the example that you just said, refinancing into potentially different term could be very beneficial. And this question comes up a lot with clients as we think about term 30 year, 15 year, sometimes you even see a 20 year term. Do you have an opinion or a thought on, is there an ideal length? What’s your opinion on that?

Mike Dillaire:

So as I said before, most people will choose the 30-year, when they start off buying the home, because it’s the longest duration. Usually, you’re in your accumulation phase, so you’re still working, not having a lot of the savings, et cetera. There’s no right answer to that, but a lot of it could come down to your cash flow. So the longer the loan, the less your monthly payment, but the more you pay overall, because of the added interest for the duration of the loan.

Andrew Busa:

Right. You work with your financial planner on that one and we can always help run the numbers on how your plan is affected by either a 30-year mortgage, a 15-year mortgage. A lot of times too, it comes down to your attitude on debt. Do you just want to be done with it as fast as possible? Or are you okay with that more spread out payment type over 30 years? So that’s fixed mortgages. We talk a lot about that. There is another category of mortgages though that is out there, that I think we should spend a second on here.

Mike Dillaire:

With fixed, there’s also adjustable rate mortgages, also known as ARM. So an ARM is a home loan with an initial fixed rate, that’s set for a specific amount of time and then, adjusts. For example, a 5/1 ARM. Very weird name, I know. But it locks in usually the favorable rate for five years and then, every one year after that, the interest rate adjusts annually for the next 25 years. It’s a, 40-year loan, but it is an adjusting rate. Often people will use these to pay a lower interest for five years and then refinance it to a fixed. So you can always refinance your loan. So again, using the five years for the favorable rate and then, refinancing back to a 30 year is something that we’ve seen a lot of.

And sometimes it can be used in environments with high interest rates, which drop. And with inflation the way it’s been in today’s economy, interest rates have risen to hopefully offset the rise of inflation. But what that means is today’s interest rates on mortgages are much, much higher than they were a few years ago. Someone did an ARM now and then, they’re getting adjusted now. Their interest rate’s…

Andrew Busa:

Right. Yeah, that’s really good context. And nobody has a crystal ball to predict what interest rates will be in the future. But it’s interesting to hear how it works. And I guess my follow up to that is, when is an ARM the right tool to think about?

Mike Dillaire:

They’re a good idea for people who don’t plan on living in that home for more than five years. And the mortgage payment and the lowered interest rate may be less than it would to cost to rent a place for five years. So some people just buy the ARM and then sell the place and profit the equity they put into the home.

Andrew Busa:

Got it. Okay. Yeah, that’s helpful to know. There are other mortgages here, but these are the two main ones, right? Fixed and adjustable. There are also different products out there like jumbo loans but these are really the two main ones to focus on. Before we leave this section, any key points just to underline, before we move on to purchasing a second home?

Mike Dillaire:

I don’t know if people would have known this too, but the interest rate that’s charged on the home is charged to you on the loan balance every year. I get that question a lot when talking about homes, ironically.

Andrew Busa:

Yeah, I don’t know if I knew that either. So that’s a good one to point out. Alright, so let’s fast-forward. That’s the accumulation phase. Let’s say we’ve accomplished that. You bought your first home. But another common situation that comes up a lot in the financial plans that we create for clients is buying a vacation home, buying a second property, whatever the case may be there. Let’s talk about that a little bit and things to be aware of here and how we can use debt most effectively.

Mike Dillaire:

So in the second home stage of the conversation today, mortgages can absolutely be used for the second home. I wanted to focus on the other types of loans that help aid the purchase of your second home. So the first one that comes to mind are our portfolio loans.

Andrew Busa:

And we see a lot of these with our clients through our partnership with Goldman. And I think it’s worth spending a few minutes explaining what this is and how they’re best utilized.

Mike Dillaire:

Sure. Our portfolio line of credit, also known as a securities baseline of credit, is a margin loan. Essentially, this means you’re using the securities in your account as collateral for the money that you receive. The loan is often easier to receive, as lenders know that you’re good for the money, because the assets are tied up in the brokerage account. And these loans are similar to mortgages and auto loans, in the sense that you’re using something tangible, so you don’t default on the loan. Like the mortgage, you’re using the home. Auto loans, you’re using a car.

You don’t see these types of loans every day, but they can be quite useful when someone needs fast cash for short periods of time and they don’t want to sell any of the securities to pay their expense. So selling securities could have capital gains and tax exposures, as well as being out of the market during a potential bull stretch. The portfolio line of credit can be similarly used to a HELOC to pay for major home renovations or hypothetical selling of one’s home to buy a new one. Sometimes, those days don’t overlap in your favor and you need to put down a payment now, but don’t have the cash to. So that’s where these loans come in handy. But similar to other loans that I’ve spoken about so far, the interest rates are quite lower than the APR on your credit cards.

Andrew Busa:

And as we think about this from a real utilization perspective, remember we’re talking about the sort of pre-retiree phase at this point. So in theory, you’re talking about a client who has built up quite a large portfolio by this stage. They have assets accumulated in an after-tax account potentially, and they’re leveraging that value to do exactly what you just said, Mike, leverage your portfolio to help bridge the liquidity that you need to make that down payment. We’re seeing this more frequently now. It’s a really interesting tool to bring up. The other one that does come up here too in the pre-retiree phase is the HELOC, the home equity line of credit.

Mike Dillaire:

Yeah, absolutely. So a HELOC or a home equity line of credit is a line of credit secured against the equity of your home. It gives you a revolving credit to use on whatever you like. So hypothetically, you could have home equity line of credit for, we’ll say, $500,000, but you only pull maybe a hundred grand of it. You’re only paying the interest on the hundred grand that you’re pulling out. They can be very well used in your financial plan, as they give a level of financial flexibility. Having access to a line of credit can come in handy when there’s a college tuition payment due or a good investment opportunity. Large credit card balance is piling up.

And now we know, from the other podcasts, that credit cards have one of the highest interest rates charged, because there’s no collateral. So HELOCs could be used to avoid these nasty credit card interest payments. And also, by using HELOCs and not your investments, it will not lead to capital gains taxes as well as being out of the market, but not to go on and change topics. But being out of the market could be detrimental to your portfolio, if you missed a few of the biggest gains in the year.

Andrew Busa:

I like it. Little bit of a plug for spending time in the market, that’s our philosophy. I think the most common use of a HELOC that we see is probably for home renovations. You also mentioned the college tuition payments, potentially debt consolidation, those are big. But essentially, this is just a way to tap into the equity of your home and pay for something that you might not want to use your account balances for. From the 2017 Tax Cuts and Jobs Act, let’s keep in mind that you can deduct interest paid on a HELOC if it is used for home repairs. So this sometimes gets a little confusing, since the rules have changed a bit.

But let’s just keep that in mind. And as we’re talking about in this section, purchasing a second home, sometimes we do see this type of liquidity used to help pay for down payments on second homes or even for large tax payments due, as it’s an easier way to free up cash than selling securities. Sort of similar with the portfolio line of credit. Now, so we talked about portfolio lines of credit and HELOCs, question for you, why wouldn’t someone use a portfolio line of credit when purchasing a first home?

Mike Dillaire:

Well, in theory, you could. Leveraging your portfolio to access liquidity for the down payment is doable, but it could become messy. Typically, portfolio loans are used for shorter periods than a mortgage. They’re used as a short-term liquidity need, rather than buying a home. Portfolio loans are margin loans. If there’s a sudden move in the market volatility, you may get a margin call and owe money to the lender. And those margin calls can be quite quick. So if you don’t have money, they could automatically sell some of your portfolio. It’s a dicey game using credit to pay debt. And the rule of thumb is to have savings dedicated for the down payment of your first home and then, that savings account for your home. I won’t get much into, but I would reference the previous podcast, Cash Is Back, that aired on August 10th, which I believe you were on with Jeff and Dan.

Andrew Busa:

Yeah, Jeff, Dan, and I, we had a really good chat about options for your cash. So we always like to plug our own content, so feel free to go back and listen to that. But I think that that’s good. That’s a really good overview of this sort of pre-retiree phase. So we’ve talked about the accumulation phase, how to use that mortgage in the best way possible for your first home. We just talked through using portfolio lines of credit or HELOCs, for maybe helping to fund a second home purchase. Let’s spend a couple of minutes in the retiree phase, where sometimes, we see another type of product show up, reverse mortgages. Let’s spend a second there. Again, this is another way that you can tap the equity of your home essentially.

Mike Dillaire:

Sure. Wanted to see if you wanted to take this one. I know you’ve worked with a lot of clients on it.

Andrew Busa:

Yeah, it has come up. And I think just high level, we do get questions about them, and let’s just cover off on some basic points. So a reverse mortgage is a loan technically, but instead of having a monthly payment, you can actually receive income, based on a percentage of equity in your home. And that income is non-taxable. Of course, there are caveats and lots of horror stories out there about reverse mortgages. But one caveat to point out, unless you’re 62 years or older, you can’t even do one. So first of all, let’s establish that you need to be at least 62 years or older.

But a reverse mortgage essentially is going to allow you to access a portion of the equity in your home. And again, those proceeds can be taken as a lump sum. They can be doled out in the form of a fixed monthly payment. They can even be held in reserve as a line of credit. And your loan is eventually repaid down the road with proceeds from the sale of your home or your estate. So I think really two big benefits to highlight for the reverse mortgage compared to alternatives, right?

Mike Dillaire:

Unlike a home equity line of credit, you don’t need to repay the loan during your lifetime. And unlike distributions from your retirement funds or investment accounts, reverse mortgage proceeds are tax free, because you’ve already put the equity in your home.

Andrew Busa:

I think where we see this pop up as a question is if a person, if they want to age in place, but they need to hire home health aides or make alterations to their property, may benefit from using a reverse mortgage to cover the costs. But keep in mind too, reverse mortgages are costly. It really only makes sense if you’re planning on staying in your home for the rest of your life and your heirs are on board with the idea that they might not receive the home, in order to, once you’re gone, selling the home to pay for the proceeds of how much debt is left. So it’s tricky waters to navigate. It’s not for everybody. And I think big picture, it’s really only useful, I would say, in situations where there’s a concern that you might run out of money, I think, before the end of your financial plan. Would you say that’s fair?

Mike Dillaire:

Yeah, absolutely. Definitely agree.

Andrew Busa:

I think it’s not something just to be used as a random tool. It needs to be done in context with the rest of your plan. So let’s wrap up with a lightning round. I always love this. We can just fire off a bunch of different information that we haven’t covered yet. So we’ve covered HELOCs, portfolio loans, reverse mortgages, regular mortgages. What else is there that we haven’t covered?

Mike Dillaire:

Yeah, I mentioned it before, but we didn’t go into it was auto loans. But I won’t spend too much time on these as straightforward and similar to mortgage. You put money down for the car, get the car, and in return, you pay the dealer the principal plus interest on the car until it’s paid off.

Andrew Busa:

Pretty straightforward. I think a lot of us are familiar with that one. There are also personal loans, right? Let’s spend a second there.

Mike Dillaire:

So we don’t typically recommend them, but personal loans, their interest rates are actually much higher than the other loans.

Andrew Busa:

Coming back to collateral, right?

Mike Dillaire:

Yeah. So everything we spoke about so far, cars, homes, portfolios, they all have that backing behind it. A personal loan doesn’t have a backing behind it.

Andrew Busa:

Similar to the credit card, where you see the interest rate be higher. And that’s what ties into your credit score too. So again, your credit score, as you talked about in our last episode together, that’s basically your transcript for how well you’ve been able to pay back all of your other loans. So your credit score, along with the collateral, is usually what keeps the interest rate on a loan around current market levels.

Mike Dillaire:

Exactly. And personal loans are more of a blend to credit cards, as you had just said, than other loans. You borrow the money, there’s an interest rate assigned, and you pay back the balance with interest, which to me, just sounds like a credit card. We would be very cautious in recommending any personal loans. As I said, the interest rates are much higher on those than home, portfolio, HELOC, anything else we talked about today. And home and auto loans have a goal. Buy the house. Buy the car. Personal loans can be used for anything. So we don’t want to see someone get into a deep hole by using a personal loan to then spend it on something that wasn’t a long-term goal or part of their financial plan.

Andrew Busa:

And I guess that leads into the conclusion. And a parting thought from me is that keep in mind that there is good debt and bad debt. And we’ve spent most of this episode talking about ways that debt can be used for good, to leverage potentially your portfolio, to buy that first home, that most of us don’t have the ability to use cash to spend on that large of a purchase. But it is a way that you can make that purchase, do it intelligently, make sure that you’re using debt in the best way possible. Any parting thoughts from you before we wrap up?

Mike Dillaire:

I think we said this on the credit podcast too: Rule of thumb, don’t spend what you don’t have, but if you do need to spend on those goals, do it wisely.

Andrew Busa:

I love it. Well, that was a lot of information today, Mike, so we appreciate you going into depth. And I’ll be looking forward to our next episode together. And again, this has been Andrew Busa and Michael Dillaire from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. And if you did enjoy this conversation, please subscribe and review our show. You can also check us out at www.adviserinvestments.com/podcast. And your feedback is always welcome. If you have questions or topics that you’d like us to explore, please email us at info@adviserinvestments.com. Thanks for listening.