Why do the wealthy borrow? Sometimes, debt makes sense

Why do
the wealthy borrow? Sometimes, debt makes sense

Family
& Lifestyle

Strategic
borrowing can keep your financial plan intact and at work.

Truths that
seem universal often fray at the edges, particularly when talking about money.

Take for example
the popular and often helpful advice from writers of bestselling personal
finance books. One common tenet is to aggressively pay down debt and then live
without it. This is great advice for many, but not everyone, highlighting how
our unique situations make a major difference. To that point:

• For spenders, people who have difficulty
  delaying gratification, this advice can be a useful and rewarding core
  discipline. Extreme spenders easily fall into credit card debt traps that
  drag on their financial situations.
• For those on the extreme saver
  side of the spectrum, this advice can instead cost potential opportunities. Not all debt
  is made of the same stuff, and risk should be thoughtfully explored before
  committing to major financial strategies.
• For those with stratospheric net
  worth, paying
  down debt immediately could prevent them from using strategies that keep
  their assets intact and able to grow while providing liquidity – simple
  income or the flexibility to react to potential investment opportunities.
  For them, debt is often an inexpensive way to manage access to cash.

And even for
people who may not be able to leverage a Dali painting hanging in their foyers,
debt can be a useful tool to keep their wealth engines running if it comes
cheaply enough relative to other opportunities, keeps their assets working for
them and, above all, if the risks are understood and tolerable. And that’s the
key. Truly understanding if debt can help you take a balanced approach to
liquidity without disrupting your investment or retirement plans or your
lifestyle.

This is
where your financial plan – one tailored to your unique circumstances,
including assets and liabilities – can open up a world of opportunity.

Examining
the details

A simple
quiz illustrates what we mean:

You are a
responsible, financially comfortable investor who has just inherited $100,000.
Your goal is to maximize the benefit. For instructive purposes, let’s ignore
the uncertainties of the market and the complexities of taxes. What should you
do with it?

A) You pay
off the $100,000 balance on your mortgage, which has a 3% fixed interest rate.

B) You
invest it into your portfolio, which hypothetically averages 6% gains each
year.*

C) You
create a rainy-day fund in a savings account earning negligible interest.

In a world
without risk, the clear answer is B: Your portfolio has an open-ended
invitation to compound onto itself. As for the other options, the mortgage has
a known, fixed cost that isn’t particularly egregious. Paying it off early may
be an emotionally fulfilling accomplishment, but it potentially comes at a
major opportunity cost. And a savings account would currently erode in the
headwinds of inflation.

There can be
a strong case to make for Option A for many investors, particularly ahead of
retirement. For established investors, Option C might not be an ideal answer
except to manage specific risks – and there are other options for maintaining
cash on hand that we’re about to explore.

*This
hypothetical example is not indicative of any security’s performance. Expenses
have not been included in the example and will affect performance.

Investment
income without capital gains

A topical
question these days is how the nation’s wealthiest individuals pay relatively
little in tax in comparison to their fortunes. The short answer is that they
don’t take a traditional income and most of their wealth is in highly
appreciated assets – like shares in the company they founded. They don’t need
to sell stocks, which would trigger capital gains taxes. Instead, they can take
loans against their shares.

Securities
based lending, securities based lines of credit, home equity lines of credit
and structured lending are options for leveraging assets without selling them.
These loans tend to have relatively low interest rates because they are
collateralized. There is a major caveat, however: If the value of the
underlying stocks, bonds or other assets no longer meet the value of the
outstanding loan, the bank will request additional securities as collateral –
or start selling. That means a market downturn can create some additional
challenges.

At the
intersection of taxes, investments, family budgets, surprises and everything
else, figuring out when it’s best to strategically borrow or when to just pay
cash can be a complicated question. Luckily, this isn’t a unique question, and at
Pendle Hill Advisors we have the tools to help.

Pendle Hill Advisors is proud to contribute to the Montgomery County
News with our weekly curated financial news and topics. If you have any
questions about the markets, your financial plan, or anything, please feel free
to reach out to our office for a no cost initial consultation.

Kent Pendleton, AAMS®

Financial Advisor, RJFS

Pendle Hill Advisors LLC

14375 Liberty St, Ste 109 | Montgomery, TX 77356

T 936-297-8267

Kent.Pendleton@raymondjames.com | www.raymondjames.com/pendlehilladvisors

Material created by Raymond James for use by its advisors. Securities offered through Raymond James
Financial Services, Inc. Member FINRA/SIPC. Investment advisory services are
offered through Raymond James Financial Services Advisors, Inc. Pendle Hill
Advisors is not registered broker dealers and is independent of Raymond James
Financial Services.

Sources:
The Wall Street Journal; forbes.com; advisorhub.com; fool.com; marketwatch.com

These
lending products may not be suitable for all clients. They may involve a high
degree of risk, including unintended tax consequences and the possible need to
sell your holdings, which may lead to a significant impact on long-term
investment goals. Market conditions can magnify any potential for loss. If the
market turns against the client, he or she may be required to quickly deposit
additional securities and/or cash in the account(s) or pay down the loan to
avoid liquidation. Further information is available from your financial
advisor.