If you want to see financial planners wince, ask for advice about the best way to borrow. Their reaction is understandable: They want you to build wealth, not spend it.
“I’m not hot on the idea-period-no matter what the circumstance,” said Charles T. Hoppe, owner of American Financial Services in San Jose, Calif. “If you get in a back-to-the-wall situation, then you have to evaluate the most desirable of the least desirable alternatives.”
The truth is, sometimes you have to borrow. Maybe you haven’t saved up an emergency fund. Maybe you don’t systematically earmark savings for specific goals, even for regularly scheduled debts such as property taxes and insurance bills. Maybe you’re going through hard times and don’t have any choice but to heap on more debt.
Where can you find the cheapest money-and how can you tell?
What you might find is that you often can essentially borrow from yourself if you’ve accumulated money in home equity, a 401(k) retirement account, cash-value insurance or securities. Each of these loans is worth investigating because they sometimes are less expensive and less disruptive to your financial plan than a conventional loan.
Don’t despair that analyzing loans is beyond your abilities. You don’t have to be a bean-counter to calculate which one fits you best. Just being aware of the variables will improve the chances you’ll make a smart decision.
But whatever you do, don’t surrender to the salesperson’s stock question: How much can you afford a month? As helpful as that might sound, it leads to a debt trap.
That question shifts your focus from the price tag to the repayment schedule. It defines how much debt you can haul on your back each month without balking at the purchase. It can comfort you if you decide to spend more than your budget allows.
But remember: To keep the monthly payment low, the lender must stretch out the payments and charge you more overall. That’s why lenders let borrowers pay just 2 percent on their credit-card balance, spread their equity loans over 20 years, drive off with five-year loans or leases and move into 40-year mortgages.
“A lot of people come in and ask, `How much can I borrow, and how much can I borrow so my payments are $300 a month?’ ” said Jonathan D. Pond, a Boston-area financial planner and author of “The New Century Family Money Book.” “My God, that doesn’t even bear comment. These people are one sandwich short of a picnic. This is insane.”
“The point is, you can live like Cleopatra for $50 a month,” added Marc Eisenson, a partner in Good Advice Press in Elizaville, N.Y. “What they don’t tell you is that it will be $50 a month for 45 years, and it will be three to four times what you started paying for.”
When comparing loans, one obvious measure is interest rates. All things being equal, the lower rate the better. But don’t stop there. Investigate the fees, the prepayment penalties and other conditions.
Then start adding it up. You can approximate the costs with a calculator, but you might find it’s easier to crank up a loan amortization program that comes with many personal finance software titles.
The goal is to calculate the total cost of the loan. You also should divide the total cost by the original purchase price so you can determine how much the loan added to your bill.
Many times, the numbers will illuminate your best choice. But don’t stop there because other factors bear consideration, namely tax issues, opportunity costs and how it all will affect your financial plans.
Tax issues are crucial because they can significantly swing the costs. Interest on equity loans is tax deductible, which can lower the real cost to you. Interest on a margin loan isn’t deductible unless you borrow the money to buy an investment, but it could save you from selling securities and triggering capital gains. Borrowing from a cash-value life insurance policy might have no tax at all.
Borrowing money also means you lose the opportunity to do something else with it. For example, borrowing from your 401(k) means that money can’t grow until you repay it. Likewise, when your insurer lends you money from your policy, it probably will cut the rate it pays on the remainder.
And perhaps most important of all, take stock of what the loan will do to your financial plan. Simply accepting the loan can derail your savings for important goals such as retirement, while also raising your debt-to-income ratio to the point where your creditworthiness becomes suspect. Equity loans put your house at risk, margin loans could force you to dump your portfolio if the market tanks, and insurance loans can reduce the death benefit your heirs would depend on.
Of course, all of this evaluation is worthless without some introspection, too. You might find loans can make spending too easy. And, particularly if you’re borrowing from your home equity, insurance, 401(k) or investment portfolio, you must ask yourself: How committed am I to paying it back?
The lack of commitment is at the root of why financial planners shiver when they give advice on how to borrow. It’s also why, ultimately, they can be so firm.
“How many people will be disciplined enough to pay it back? Probably nobody,” said Barbara McAtee, a financial planner for IDS Financial Services Inc. “It’s called a fantasy. If you can’t make a commitment to pay back the loan, don’t do it.”
The language of borrowing
– After-tax cost. Because interest on mortgage and equity loans generally is tax deductible, tax deductions can significantly lower the interest rate you actually pay. In addition, the higher your tax bracket, the bigger the effect. For instance, a 9 percent mortgage is equivalent to a 6.48 percent rate for someone in the 28 percent tax bracket or 5.44 percent in the 39.6 percent bracket.
– Debt-to-income ratios. Mortgage lenders commonly apply a “28/36” debt-to-income benchmark. This means they don’t like to see your total monthly housing debt exceed more than 28 percent of your gross monthly income and your total monthly debt payments exceed more than 36 percent.
– Leverage. Borrowing can help you buy a much more expensive asset than you otherwise could afford on your own. To understand why leveraging makes buying real estate so attractive when home prices are rising, say you buy a $200,000 house by borrowing $180,000 and paying a $20,000 down payment. Your equity is 10 percent. If the home’s price rises 10 percent to $220,000, your equity jumps 100 percent-to $40,000-yet you have invested nothing more. Conversely, leveraging can be disastrous when prices drop.
– Opportunity cost. The amount you forgo when you make a choice. For instance, say you own a 401(k) retirement account earning 10 percent. Borrowing $5,000 from the account means you will sacrifice the opportunity to earn that 10 percent.
