What Makes Mortgage Debt Different?
Understand the Rewards and Pitfalls of Collateralized Borrowing
A question that keeps coming up is “Should I pay off my mortgage”? The follow up is usually something like, “I don’t want to have any debt when I retire”.
While I agree that having debt in retirement is something to avoid, I want to make the distinction between collateralized borrowing and other debts.
What is the Difference Between Collateralized Borrowing and Other Debts?
Using debt to finance your lifestyle like vacations, dining out and buying clothes can create a drag on your wealth that might prevent you from ever being able to have a secure and comfortable retirement.
Financing drag on purchasing any item or experience that does not increase in value, multiplies the cost and thereby the negative impact on your wealth.
After all, not only do you lose the ability to earn interest on the money you spent (lost opportunity cost), but now you are adding to the lost opportunity cost by losing the ability to earn interest on the interest you are paying!
This can create a negative chain of events that often leads to bankruptcy or other financial stress.
What is Different About “Collateralized Borrowing”?
First, lets define what this type of borrowing is. When you have an asset like a business, a piece of real estate, stock portfolio, etc. you invest to earn a positive rate of return.
Generally, the only way to enjoy the benefits of that rate of return is to sell the asset, otherwise the value is locked in the asset.
After all, if you want to go to the grocery store, you can’t take some bricks from your home and use that to buy food, you need cash.
However, when selling an appreciated asset, you will usually have to pay taxes, so now you face the conundrum of selling and paying the tax cost, or having your equity stranded in that asset, unable to be spent, used to pay for an emergency expense, or invested in other opportunities.
Three Positive Options that Borrowing Can Create
Option #1: If I am able to use the asset as collateral, I am able to control the value of the asset on my terms, not those of a banker or buyer, which is the only other way to access the value locked in that asset.
Option #2: I have the ability to create and benefit from the “velocity of money and multiplier effect”. This is how our economy is able to grow. If I am able to use the same dollar and earn a positive return, or eliminate and expense, I am taking advantage of that velocity and using it to multiply my wealth, without dramatically increasing my risk exposure. In fact, if used properly, you can use this to greatly DECREASE your risk exposure, while greatly INCREASING the growth of your wealth.
Option #3: I can increase my liquidity. Many assets that grow in value are not liquid. Some of the best ones are very illiquid. Think about your house. I know the market is hot right now, but back in 2008, if you needed to access the value of your equity, you couldn’t do that by borrowing. Banks were not doing cash out refinancing. And if you sold, the market was so bad that buyers were only offering pennies on the dollar. Having access to cash in times of stress is one of the most important considerations one can have, especially in retirement.
How Do the Wealthy Often Avoid Paying Taxes?
According to an article recently published in the Wall Street Journal (WSJ 7-12-21), low interest rates have been a huge boon to wealthy folks who follow the “buy, borrow, die” strategy.
In this strategy, one buys appreciating assets that will grow over the long term, borrow against those assets to avoid capital gains and pay for their lifestyle (tax free) and then when they die, their heirs avoid paying capital gains taxes due to the “step up in basis” one’s assets receive at death. The heirs then pay off the loans by selling those assets and not paying any taxes.
Knowing the Rules Will Help You Win
If you are going to play a game, it is important to know the rules if you want to be successful. Wealth building and maintenance are really a game and the rules are those of the tax code, mathematics and economics.
Like Tic-Tac-Toe, once you know the rules, you are not as likely to lose. Reducing taxes automatically increases your wealth. After all, it isn’t how much you have, it is how much you get to spend of it that counts in the end.
This is a lesson folks who have all of their assets in a tax deferred retirement plan like an IRA or 401k often are shocked to learn about after they retire. Wanting to “save” on taxes now, they contributed the maximum to those plans, but now understand that the money in one of those accounts belongs to them and the taxman!
Using Your Equity to Build More Equity
I am just finishing up on refinancing my home. The value has increased, on paper, tremendously over the past few years.
Unfortunately, I live there and can’t take advantage of that increase unless I sell.
Having lived there for more than 15 years, we had some upgrades and normal maintenance that we wanted to do.
After doing the analysis, we took out a home equity line of credit (HELOC) to pay for that work. This way, we get to use money that was earning a guaranteed 0% rate of interest to pay for those improvements.
Once the work was completed, we are now refinancing to combine the 2 loans and reduce our debt service dramatically.
This has the effect of increasing our cash flow, reducing our taxes (because we itemize and qualify to use the mortgage deduction) and reducing the risk of loss on the property.
Oh yeah, the value has increased as well.
Ultimately, I encourage folks to pay off that mortgage, just not to the bank. I wrote about this several years ago in greater detail. You can read that post here.
The Bottom Line
Hopefully, this has gotten you to think twice about your home and other real estate equity as an asset, that when combined with low interest borrowing using the property as collateral, can increase your wealth, increase your lifestyle, increase your financial security and decrease your risk exposure.
This will work with many types of tax deferred assets (just not retirement plans, it is against IRS rules to use a retirement plan as collateral) like collectibles, stock, business interests and permanent life insurance policies while still providing the benefits and strategies we have touched on here.
Give us a call if you would like to learn more on how to use this strategy for your own benefit.
Roger holds the coveted and well-earned designations of Chartered Financial Consultant (ChFC®) and Retirement Income Certified Professional (RIPC®) from the American College. He is also a licensed insurance agent for life and health insurance and a Certified Paralegal for Estate Planning.