Steve TeSelle, CFA, CFP ™
February 2002
Does It Always Make Sense to Buy a House With Debt?
Debt evokes different feelings for different people. Some people view debt as slightly better than the plague; others don’t think twice about loading up the liability side of the balance sheet. Part of this difference probably has to do with expectations for the future. If you tend to think of all the things that can go wrong, debt probably scares you. If you think that big money is just around the corner, debt probably doesn’t bother you too much. I start out a discussion on debt this way because there’s no simple answer to whether an individual should take on more debt. The answer depends on both financial factors and personal preference.
In itself, debt isn’t a good thing or a bad thing, it just is. Most of us need to take on debt in order to buy a home. In this case, you take on a debt in order to acquire a valuable asset that is likely to appreciate in value.
People also take on debt to buy a car. Many of us don’t have in our back pockets the thousands of dollars it takes to buy a new car. In this case, you’re taking on debt to purchase a valuable asset, but one that is likely to decline in value. In fact, if you try to sell your new car after one year, you’ll probably get less than you owe on your loan.
Then you might take on debt to go on a vacation, or to cover living expenses that you hadn’t quite planned on. The credit card is ready and willing to help you out. But this is where people really get into trouble, where they are living beyond their means. Without some change in circumstances, spending more than you earn can’t last indefinitely.
Living beyond your current means makes sense only if you know that your future income will be higher. I tend to be the type who thinks of all the things that can go wrong, so I don’t like to count on future income. But fortunately for our economy not everyone is just like me. Some folks might feel quite comfortable going into debt to cover current living expenses, with the expectation that cash flow will only get better.
In general, taking on debt makes financial sense for an asset that is appreciating.
You may also need to borrow to purchase a depreciating asset, but you’re essentially
using debt proceeds to pay for your operating expenses. 
[top]
People who lend money generally want to get repaid with cash in regular, agreed-upon payments; they’d rather not hassle with sales of assets, repossession, and bankruptcy. This is why lenders love folks with steady jobs who have more than enough cash flow to meet their debt payments.
However, even steady jobs can get restructured away. Yet the loan payments come due with the regularity of a Swiss watch. If you can’t meet the payments, you may have to sell the asset before you’re ready, perhaps when the asset value has dropped.
The general guidelines are that your mortgage payment should not exceed about
30% of your gross income (before taxes) and that total debt payments should
not exceed about 35% of your gross income. Guidelines are general rules, not
incontrovertible truths. Your particular situation could make the guidelines
look pretty silly, if, say, you have a sizable stash of money in liquid assets.
[top]
Congress has changed its collective mind a few times regarding debt and taxes. As of February 2002, only mortgage-related debt gets favorable tax treatment for the individual taxpayer. That is, the interest portion of the mortgage payment is deductible against income, if you itemize your deductions (or have a rental property). Of course, tax rates and tax rules can change.
Usually, buying a home is a good long-term investment. Assuming you’d want to live in a comparable house whether you own or rent, owning always comes out on top as long as house prices increase. You could run into trouble if you expected to own for the long term, but circumstances force you to sell in the short term. While housing has increased in value when measured over long periods, over shorter periods prices can fall significantly.
Most of us don’t have the resources to buy a house with cash, so we need to
borrow in order to buy. But what if you just happened to have a large account
balance, and could buy a home with cash? Leaving aside the issue of diversification,
borrowing would still make sense as long as you could earn more than the after-tax
cost of debt. For example, if a 30-year mortgage costs 7%, you’re in the 30%
marginal tax bracket, and you are able to itemize deductions, the after-tax
cost of the mortgage is less than 5% per year. If you could earn more than
5% per year after taxes on other investments, a mortgage makes financial sense.
Now if debt makes you so nervous that you toss and turn when you should be sleeping,
or if you put your money only into bank certificates of deposit that yield less
than 5% per year, the mortgage doesn’t make sense. [top]
If taking on debt for an appreciating asset is a good idea, then it must be
a good idea to have a margin account, or take out a home equity loan, to invest
in the stock market. Hmm. Not necessarily. If you could get a guaranteed
10% return on stocks, and debt cost you 7%, then taking on debt for a stock
investment would make sense. And if stocks rise 20-30%, you look like a genius.
But if you take on 7% debt and the expected 10% fails to materialize, then things
don’t look so good. If, at the same time, that safe job you thought you had
evaporates, things can look really crummy. [top]
The key thing to remember about debt is that the more of it you have, the less flexibility you have if something goes wrong. If income doesn’t arrive as expected, the lenders are the ones who get to call the shots, not the borrower.
OK, I get it. Less debt equals more flexibility. But if this has anything to do with our anniversary, you’re toast.
[top]
© Dorato Capital Management, LLC. All rights reserved.
Back
to Home Page
portfolio management, investment management, investment
planning, financial planning, DORATO Capital Management LLC, Dorato, Steve TeSelle,
investments, finances, investing, portfolio, portfolio management, investment
management, investment planning, financial planning, DORATO Capital Management
LLC, Dorato, Steve TeSelle, investments, finances, investing, portfolio, portfolio
management, investment management, investment planning, financial planning,
DORATO Capital Management LLC, Dorato, Steve TeSelle, investments, finances,
investing, portfolio, portfolio management, investment management, investment
planning, financial planning, DORATO Capital Management LLC, Dorato, Steve TeSelle,
investments, finances, investing, portfolio, portfolio management, investment
management, investment planning, financial planning, DORATO Capital Management
LLC, Dorato, Steve TeSelle, investments, finances, investing, portfolio, portfolio
management, investment management, investment planning, financial planning,
DORATO Capital Management LLC, Dorato, Steve TeSelle, investments, finances,
investing, portfolio, portfolio management, investment management, investment
planning, financial planning, DORATO Capital Management LLC, Dorato, Steve TeSelle,
investments, finances, investing, portfolio, portfolio management, investment
management, investment planning, financial planning, DORATO Capital Management
LLC, Dorato, Steve TeSelle, investments, finances, investing, portfolio