We have historically low interest rates, yet some folks haven’t gotten around to effectively managing their use of debt. Regardless of whether the economy is in the midst of a traditional interest rate cycle (heading upward sooner than later) or some aberration (see Japan’s 25 years of persistently low rates), it still makes sense to review your personal debt structure.
There are some fundamentals that everyone should evaluate to make sure they’re using the right kind of debt, in the right ways and at the right times.
One of the first measures to take into account is what interest rate is being charged on outstanding loans. Today, some 30-year mortgages are under 4 percent. Individuals who have an existing balance on a loan that will be paid on for a number of years should shop for a fixed 15- or 30-year loan with an interest rate below 4 percent.
If the new rate is 1 percent below the current rate, it will take about 12 months to recover the closing costs of the new loan on a $150,000 mortgage. A homeowner is ahead of the game every month after that initial period.
Often, people make the mistake of locking in a 15- or 30-year home loan when they know they won’t be living there that long. If they instead go with a five-year adjustable rate mortgage (ARM), they could get a rate closer to 2.5 percent.
Even if the rate increases after the initial rate lock, it’s likely that the early, lower rate will offset a couple years of higher rates as the loan matures. The balance should also be lower in future years, meaning there is a smaller principal on which interest is charged. It’s good to match the term of a loan to how long homeowners expect to need it. That way, they can avoid paying a higher interest rate to lock a loan term that won’t be used.
Interest and Diversification
Another consideration is whether a loan has tax-deductible interest. For those who itemize deductions on schedule A of their federal income tax return, interest paid on primary and home equity (HELOC) loans is often deductible. Rates for HELOCs are usually pegged to the prime lending rate, which today is around 4 percent. If deductible interest costs 4 percent and a person is in the 25 percent marginal tax bracket, his or her “net cost capital” is just 3 percent, which is quite low.
Some question whether it’s a good idea to accelerate paying off debt at today’s low interest rates. If a couple pays off their mortgage, they will now own one asset, in one location, with one use—their home. That’s not good diversification.
Instead, they could invest their extra mortgage payments in other types of assets to have greater diversity. They would be gambling that they could beat their net cost of capital by investing elsewhere, instead of paying down their mortgage. But they also wouldn’t have the psychological dividend that, no matter what, they own their home.
Another popular borrowing vehicle is a 401(k) loan, which is available to many company retirement plan participants. The limit for these loans is 50 percent of the participant’s account value, up to a maximum of $50,000.
Most often, the interest charged on these loans is credited back to the participant’s account, making the cost of this loan effectively 0 percent. Generally, the repayment period is five years, which includes a requirement of making payments at least quarterly. If a person changes jobs, the loan has to be paid back or the remaining balance becomes a taxable event, including possible penalties.
When shopping for credit, timing is everything. The best time for individuals or companies to line up a loan or do a thorough review of debt usage is when they don’t need to borrow any money. This is when lenders are most eager to offer their best terms. If a person or company badly needs to restructure or get additional credit, chances are there will be few lenders willing to take the risk, or offer reasonable terms. It’s best to set up all lines of credit when they aren’t needed so they’re available when they are.
Today’s low borrowing costs could be the lowest seen in our lifetimes, and won’t be here forever. Now is an excellent time to review one’s rates, terms, tax treatment and sources of available funds. Perhaps five or 10 years from now borrowers (and investors) might be wondering, “What the heck were we thinking? We should have borrowed as much as possible at those ridiculously low rates.”
Gary Vawter is a Certified Financial Planner and the owner and principal advisor of Vawter Financial. He can be reached at (614) 451-0002 or firstname.lastname@example.org.
Reprinted from the November 2012 issue of Columbus C.E.O. Copyright © Columbus C.E.O.