When debt is ok or DEBT is not a 4- letter word Posted by host on 6/2/2010 3:19:52 PM “Neither a borrower, nor a lender be” says Polonius in Shakespeare’s Hamlet.
“… the borrower is servant to the lender,” Proverbs 22:7.
Perhaps you have parents who grew up in the Depression years. Do you remember older relatives who talked about how many sandwiches they could make out of one banana or one tomato? If you grew up in an environment where money was scarce, you may have a commonly held fear of running out of money.
Or, perhaps due to the tenets of your faith, you believe that having debt is bad and being debt-free is good.
I won’t try to dissuade you from your emotions about money or argue with your spiritual beliefs. But I will try to change your paradigm about “Money in Motion” and how you can use your money and debt to your advantage.
SMART Group Houston recommends keeping your fixed obligations such as mortgage commitments to less than 25% of your gross income. Financial institutions normally allow higher than 25 % of gross income as guidelines. If you have always worked toward becoming debt-free, this strategy may seem counter-intuitive.
Let’s start with the home mortgage. We see people who are working diligently to build up equity in their homes or who subscribe to financing programs where you pay extra payments or twice monthly to reduce your total interest outlay over the course of the loan. I’ll admit to being a bit squeamish the first time I bought a home and had to sign off on the total interest page of the closing documents. Seems a bit daunting even to the most courageous buyer. However, until the IRS code is reformed, home mortgage interest remains one of the few opportunities to reduce your adjusted gross income for federal income tax purposes. When you pay off your home mortgage around the same time your children are leaving home, you are giving up two key income tax deductions at the same time.
How much interest are you earning on your equity in your home? Is it an asset that is at work for you? I encourage you to think about my Money in Motion Solutions® and keep as many assets at work at the same time.
How does the interest rate on your mortgage compare to that of your other consumer debt such as credit cards? If you are like most people and have re-financed recently, you might have a mortgage in the 5-6% interest range. If you are carrying credit card debt and making payments that are less than the full balance each month; you might be paying anywhere from 8-20% in interest on the balance. The same goes for department store or home improvement store charge cards. Does it make sense to pay off the loan with the lowest interest rate before paying off the ones with the higher interest charges? Majority thinking would have us chip away at the largest loan. SMART Group Houston recommends paying off the balance of your highest interest rate non-deductible loans first.
Equity Extraction
Home loan rates remain at historical lows. Generally speaking, the longest-term loan allows you the greatest potential write-off for your mortgage interest. By that I mean over the longest period of time. Debt for the sake of debt is bad. Home loans are a fixed obligation. SMART Group Houston can assist you in evaluating mortgage choices to apply them to your unique situation.
Example: A fully deductible 6% loan in a 30% marginal tax bracket, after allowing for income tax savings credits, would be, in effect, a cost of 4.2% money. Think of that payment as the cost of shelter.
Money in Motion Solutions®
At SMART Group Houston, we work with people to build additional blocks of capital for those later years when they want their money to be “at work” for them, instead of going “to work” themselves. Our goal is for you to have a block of capital available to you at such time as it makes sense to pay off your mortgage or to meet other objectives you have in mind. When people that are concerned about carrying mortgage as a debt see that they are building other assets to pay it off, debt becomes a tool for keeping their money in motion instead of a 4-letter word.
High consumer debt with maximum 401(k) contribution
Do you make the maximum contribution to your 401(k) plan at work while you have outstanding credit card debt? Take a look at your gains in your savings plan over the last 12 months. Do they exceed the interest rate you are paying on your outstanding credit card balance? Keep in mind that your 401(k) is a decision of timing on taxes. Carrying high consumer debt means you are losing money every month. You may want to consider reducing or suspending your 401(k) contribution for a while and apply what you had been saving to paying off your consumer debt. Once your debt is paid off, you can reactivate your 401(k) contribution (up to the company match). You should probably check your plan policies. Some plans have limitations on how many times during the year you can change your contribution. If you suspend your contribution, you may have to wait until the next plan year to start again.
Example: Sally’s 401(k) plan showed an increase of 4% over the last year from interest, dividends and appreciation, not including her monthly contributions or her employer’s match. This surpasses what she might have earned at her local bank or credit union. For this example, let’s say she has $10,000 in her plan. Her earnings for this year would be $400 on the $10,000 balance. However, she has about $10,000 on her major credit cards and one department store charge card. At 18% interest on her running balance, she is paying out $1800 per year. She “earned” $400, less the future income tax, while paying out $1,800 in negative savings (non-deductible debt). Sure looks to me like Sally is upside down on this money decision! It cost her $1,800 to earn $400 in this example.
Note: At SMART Group Houston, we’re not opposed to 401(k) plans, we just caution participants to contribute just up to what their company is matching, and in some cases, to suspend or reduce their contributions until they can eliminate their non-deductible consumer debt.
Many of our more mature clients who have faithfully followed the myth of maximizing their 401(k) plans are surprised. The surprise is they are forced into higher tax brackets, when withdrawing from their retirement nest eggs because of IRS-mandated minimum withdrawals. If you had a choice of taking income in 2010 or 2011 and you would be in the highest tax bracket, which year (2010 or 2011) would be the best year to recognize income? Call us if you’re not sure of the correct answer.
Coordinating your assets and liabilities (debt) and having them work in harmony helps create a Money in Motion Solutions® for your lifetime. SMART Group Houston is an independent firm focused on you. We apply our intellectual capital to your unique set of circumstances—financial services being one of our distribution channels.
SMART Group Houston does not provide specific legal or tax advice. Financial decisions should be made in consultation with your attorney and tax advisers. No specific investments are recommended or implied.
SMART Group Houston, 5151 Katy Freeway suite 208 Houston, TX 77007 Telephone: (713) 984-8044, Toll Free: (888) 894-6600, Fax: (713) 984-8048 Securities offered through Resource Horizons Group , L.L.C. Member FINRA, SIPC 1350 Church St. Ext NE, 3rd floor, Marietta, GA 30060 770-319-1970 Advisory Services offered through Resource Horizons Investment Advisory
April 2010
