September 27, 2021

In order to Borrow Or Not to Borrow? : The 3 Rules for Debt Money

Like a financial advisor, I continually get asked by my clients when they should borrow money for certain activities such as buying a home, open lines of credit to get a business or pay off consumer debts such as credit cards and car loans.

The basic principle in borrowing money would be that the interest and other costs of acquiring the loan are less than the value which is created by borrowing the money. As an example, if one borrows money at 4% and creates a 7% return, all else being equal, then there is a 3% profit or “positive arbitrage” come back on that investment. The objective is to get the greatest rate associated with return with the lowest cost so income are maximized.

Assets such as homes and businesses can be used as security to secure a loan. One can also work with a consumer asset such as a car or his signature, as in a credit card.

But when should one borrow and when ought to debts be paid off ASAP?

Nicely, there are three factors that figure out when a person should borrow cash. They are income, appreciation, and tax benefits.

1 . Income – Money should really be only borrowed against assets that produce an income. Industrial and investment real estate and other company operations produce income since the resource is used in business to provide a valuable support to another for money. This income may then be used to service the debt owed on the asset.
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Personal assets like primary residences, cars, and personal credit lines do not produce income.

2 . Gratitude – One may borrow money towards assets that would, over the long-term, value in value. Even if the income when you use the asset did not provide enough income to pay off the debt, the later sale of the asset would be at a higher value in the future so the financial debt could be retired upon sale. Commercial and investment real estate have the potential for appreciation as well as businesses as they develop in value through expansion. Principal residences may or may not appreciate in value, depending on the market plus holding period. Consumable assets like cars, boats, and personal credit lines usually do not appreciate but decline in value.

3. Tax Benefits – The federal government will pass laws that permit certain types of indebtedness to have preferential treatment in the tax code. Whenever you borrow money for business reasons, the interest and other costs associated with the loan may be tax-deductible. Since you are getting a rebate on the taxes you would in any other case owe, your cost to lend the money is less. This creates an even larger gap between the borrowing cost and the value realized from putting those assets to productive use.

Another tax benefit might be in the form of depreciation. An asset purchased intended for business use is assumed in order to decline in market value over a specific period of time. The tax law enables a taxpayer to claim every year’s depreciation of the value of the asset against other income. This actually also has the effect of lowering the cost of borrowing.

When you are determining whether to lend or not, you will have the greatest chance of revenue if ALL 3 factors can be found in the borrowing decision. This would just include borrowing for business purposes such as commercial or investment real estate and business debt. If you have two or 1 out of the 3 aspects, pay it off quickly.

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