Debt has gotten a bad rap for a very long time. The Bible, the Koran, the Talmud, Shakespeare, Adam Smith, and countless other sources of wisdom have all have gotten their jabs in. “A man in debt is so far a slave,” Ralph Waldo Emerson opined. “The second vice is lying,” Benjamin Franklin wrote. “The first is running in debt.”
But used correctly, debt is a powerful way to build wealth. It helps us become homeowners and often fuels our education. It can create or improve prospects for earning. Managing debt, notes Larry Rosenthal, founder and president of Rosenthal Wealth Management Group in Manassas, Va., helps people put capital where it’s best deployed. In the past several decades, for instance, homeowners who focused on paying down their mortgage would have made more money investing in stocks. That’s because the stock market has performed better in the past three decades than home prices nationwide.
“What you’re looking for is whichever instrument lets you pay the least out of pocket and optimizes your cash flow over time,” Rosenthal says. The goal is to pursue good debt—borrowing to help improve your financial prospects—and avoid bad debt, for unnecessary expenses. All the more power to you if the debt you choose is tax-favored and payments are deferred.
To learn more about how to better manage your money, visit the Investing Center.
The key to employing debt properly is knowing what and when to borrow, where to borrow from, and when to refrain. Here’s a rundown of how best to leverage your money in several life situations:
National data published by Home Remodeling magazine shows that you can’t completely recoup your investment in improvements when you sell. So right off the bat, understand that you probably can’t turn a kitchen redo or new deck into a profit. But the IRS rewards certain types of loans for home improvements with special tax treatment, making that type of borrowing quite attractive. Joint filers can deduct interest on debt of up to $1 million that’s used to buy, build, or improve a first or second home; single filers can deduct up to $500,000.
ReKeithen Miller, a certified financial planner with Palisades Hudson Financial Group in Atlanta, maintains that a home equity line of credit is the best type of loan for that purpose because though its interest rate floats, it is usually less than those of other types of loans. A $50,000 HELOC at, say, 4 percent—the average rate in late summer for borrowers with stellar credit, according to Bankrate—would actually cost just 3 percent after factoring in the tax deduction, assuming a marginal tax rate of 25 percent.
Next best to a HELOC? A home-equity loan, Miller says. It gets the same tax treatment as a HELOC, but its interest rate, although fixed, is usually higher. When we went fishing for home-equity loan rates on Bankrate in late summer, annual percentage rates were around 6 percent, vs. 4 percent for HELOCs. But Bankrate showed one lender—Pentagon Federal Credit Union—that offered a lower rate (3.24 percent annual percentage rate) than that of the average HELOC.
After exhausting scholarship and grant options, students and families should turn to federal direct student loans. Currently, the fixed rate for subsidized and unsubsidized Stafford loans is 4.66 percent for undergrads, with a 1.073 percent up-front fee. (Students qualify for subsidized loans if their school determines they have financial need, defined as the cost of attendance minus the family contribution.) With subsidized loans, the federal government pays the interest while the student is in school; with unsubsidized loans, students can opt to either pay the interest while in school or have it accrue unpaid while they’re in school and added to the principal when they leave. Then they begin to pay back principal and interest.
Many taxpayers may be able to exclude up to $2,500 of qualified student loan interest from adjusted gross income. Because a lower AGI lowers your taxable income, it also might improve your ability to itemize income-based deductions.
Fixed-rate, direct federal Plus loans for parents, like direct unsubsidized loans for students, can be taken out regardless of income, assuming the borrower has no adverse credit history. But those federal education loans carry higher rates of interest than Stafford loans, currently 7.21 percent, plus a 4.29 percent loan fee. They’re an option for remaining education costs once the student borrows the maximum $27,000 in direct loans. Though there’s no borrowing cap, it’s best not to borrow beyond a student’s needs.
Parents with great credit who can qualify for a HELOC with a significantly lower rate of interest might want to use that option first. But they’d have to start paying interest on the loan right away. And interest on a HELOC can be counted only as an itemized deduction. And the higher the income, the greater the likelihood that a portion—or all—of the deduction will be disallowed.
Mark Kantrowitz, senior vice president and publisher of Edvisors, a college-finance website, says students and parents shopping for loans should take into account interest rates and other loan features. Indebted students who enter public-sector jobs and not-for-profit jobs in public service can have their federal loans forgiven after 10 years of good payment history; they also can take advantage of flexible payment options such as deferments, forbearances, and income-based repayment schedules for graduates who don’t make much money. (Plus loans don’t qualify for income-based repayment plans.) “Nobody plans on running into financial difficulty,” Kantrowitz notes. “Students tend to assume that they won’t need these repayment benefits.”
But based on interest rates and fees alone, Kantrowitz says a HELOC is about on par with private student loans from banks (no flexible repayment or forgiveness options). He says it’s far better than other financing options, such as unsecured personal signature loans from a bank or credit union (high interest and little flexibility), 401(k) loans (see box at left), and credit-card debt (very high interest and potentially fee-laden). As a general rule, students should not borrow more than they can earn in their first full year of employment, he says.
Small-business owners with good credit and some collateral may be able to take advantage of bank loans or loans through the U.S. Small Business Administration (sba.gov). With an SBA loan, a bank makes the loan and the SBA guarantees it. The most common SBA loan, the 7(a), can lend up to $5 million; loans of up to $150,000 have no fees and are guaranteed up to 85 percent by the SBA. Interest is based on one of three base rates chosen by the lender: the published prime rate, the London Interbank Offered Rate (LIBOR), or the SBA “optional peg rate.” (In early September the SBA peg rate was 3 percent.) For fixed-rate loans of up to seven years, lenders can add up to 2.25 percent to the base rate, so it pays to shop around. Among the SBA’s many requirements, applicants must have some of their own equity invested in the business and must have used alternative financial resources before seeking a loan.
A number of small businesses use credit cards as a source of funding. A 2012 study by the National Federation of Independent Business found 22 percent using their cards for long-term credit. But as we show in the box at right, businesspeople—and others—should approach that method with caution.
Be cautious about loans from friends and family, too. Mess up the deal and you’ll hear about it forever—if the two of you are still talking. So create and sign a written contract with your lender, specifying factors such as the amount, rate of interest, and method and duration of repayment. Have it notarized. To avoid having the IRS consider the loan a gift—potentially subject to gift tax—pay at least a minimum interest rate, known as the applicable federal rate. In September, the annual AFR for loans of one to three years was 0.36 percent. For loans of more than three years and up to nine years, it was 1.86 percent. Buy and download a promissory note for less than $15 from Nolo or Legal Research Group (ilrg.com/forms/promisry.html).
You also could ask for help from strangers. Websites such as Lending Club and Prosper help pair individual borrowers and lenders. You apply for a loan and indicate how you will use it, for how long, and other factors. Lenders pull your credit score and make offers. You receive a lump sum, with an interest rate of about 6 percent to about 30 percent (Lending Club) or 6 percent to 40 percent (Prosper), depending on your credit score. The good news: Both sites say your credit score isn’t affected when you request a quote.
Miller warns business owners to avoid borrowing from home equity. “It’s one thing to lose a business but another thing to have a bank foreclose because your business went under,” he says.
No matter how you borrow, protect your family and home from foreclosure by setting the business up as a limited-liability corporation. “That way, your home and other personal assets will not be at risk if your business were to go under,” Miller notes. But an LLC won’t protect you if your home is used as collateral.
Mandated health insurance for all Americans means that in theory most people will no longer face extreme health care bills of hundreds of thousands of dollars. There are limits on the out-of-pocket costs for plans purchased through state insurance marketplaces. For 2014, those out-of-pocket maximums amounted to $6,350 for individuals and $12,700 for families. Those with employer-sponsored coverage also may face high costs. In 2015, high-deductible health plans are permitted to charge families as much as $12,900 a year in deductibles and co-pays, according to the IRS.
Before shouldering any medical debt, make sure the health provider hasn’t made billing mistakes that have run up your bill. Such errors are common, according to Mark Rukavina, principal at Community Health Advisors, a health care consultancy. Question charges, and ask whether the provider offers financial assistance. (Nonprofit hospitals are required to have financial-assistance policies; many other providers have them, too.) Negotiate with your providers for lower payments and flexible payment options. The not-for-profit National Foundation for Credit Counseling (nfcc.org) can connect you with a credit counselor who may be able to exert more muscle in negotiating.
Avoid putting medical debt on a credit card, especially if you carry a balance. Unless you’re confident juggling zero-interest cards, the regular interest rates can be crushing.
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