Should I increase my debt?

I’ve been recently pondering whether we should be doing more in respect of increasing our overall gearing to more build wealth and shelter tax. There are a few factors that I’ve been mulling over as far as this decision is concerned. 

We’ve come along way as far as making substantial inroads in bringing down our total outstanding debt. At one stage, our overall debt to total asset was well over 40%. Now it probably stands at just under 15% of total assets. Our assets have gone up significantly since that period and the debt balance has markedly come down.

I’ve never had much if any debt against personal property assets that depreciate. The car loan, or financing for electronics are things I don’t believe in. They’re all bad debt. If anything, I’d take those loans out for a few months and fully pay them off to keep my credit score in good nick and minimize any interest payments.

What I have had is plenty of good debt. Is there really such a thing? Isn’t all debt just debt?. In my books, any debt that helps build income producing assets, generates wealth and is provides you a tax shield is good debt. I’ve had debt that I’ve taken out to fuel my purchase of dividend stocks (though I may have gone overboard with it at various times!), and debt against our condo, which should probably extinguished within the year.

Why have I been thinking about this lately? As part of digging into how we are working through our approach to retirement accounts, it occurred to me that tax is the biggest current leakage that we have to worry about. Once you work through federal taxes, state taxes, payroll taxes, FICA etc, you’ve lopped a big chunk out of what’s available net of tax to be taken home.

Retirement accounts help, but you can only shelter $17,500 annually. In our case, that still leaves a substantial balance of income looking for tax shelter. Another great way to shelter current tax expense is through tax deductible interest expense, particularly if it can be used to grow additional assets. The question I’ve been wrestling with is what assets, if any, should we look to grow.

The new house

I’ve mentioned previously that we’ve actively been looking for a new place, which we are hopeful that we’ll be able to finalize early in the new year. Of course, we aren’t after the new house just for the tax benefits…although they’re certainly be some of those… frankly we need a bit more room for our kids to run around and enjoy themselves like all kids do, and the condo isn’t cutting it any more.

Something else has also been happening with our condo that I’ve noticed as far as impact on our tax profile. As we’ve been crazily  repaying the debt with a rapidly accelerated debt repayment profile, the favorable tax shield we received in the first few years has been diminishing. We are now down to a small chunk of principle and change on interest.

I’ve been worried for a little while now that not only will we be losing a tax shield once the condo debt is paid off… but we’ll have excess capital that will be freed up on a monthly basis that I’ll need to put to work somewhere. Given the substantial balances on our equity holdings, I really don’t want to be ploughing so much more excess capital into a single asset class. Having the house + mortgage will be helpful to direct some of this excess capital into asset diversification and having a new source of tax deductible debt as well.

The other thing I like about the house from an asset perspective is that in general, it’s pricing and valuation is pretty stabile. Sure house prices move around, up and down, but you don’t see them move around 2-3% on a daily basis. Perhaps it’s partly perception, but I think this stability is not lost on the banks, who generally allow a greater level of debt to be taken against housing compared to say buying stocks on margin.

Housing valuations aren’t great, but I don’t think they are in bubble territory just yet. Given we’ll be plonking down a pretty decent sized deposit, the risk of being under water is fairly limited in my view, and therefore the risk of needing to increase equity contributions is also pretty limited. No forced margin calls is a big positive!

So the new house and the accompanying mortgage debt will help with the restoration of asset diversification as well as helping with better tax efficiency and help our excess capital get diverted somewhere other than to cash and stocks. I estimate with the new house and it’s accompany debt, we’ll be back to a debt to asset ratio of around 35%, still manageable without being uncomfortable.

Do I dare go further ?

Beyond the natural increase in debt that comes with the new house, the next place to potentially add some debt is in my taxable account. I’m currently carrying a modest amount of debt here, but there would be the possibility to ramp this higher.

Given that I won’t be contributing as much to my taxable account due to maxxing out my 401k, the natural temptation is to restore the balance by dipping a little more into margin to come out on par. I’m wary of doing this for a few reasons.

I’ll likely be looking for a little bit more “alpha” in my taxable account. My 401k is going into the equivalent of the S&P 500. Large cap leaders with a reasonable amount of stability. Thus the taxable account could afford to take on a little more risk, hence I’ll be looking for a few more growth companies and maybe a few small cap early stage companies to include in the mix.

The biggest problem with these stocks is while they may good long term growth prospects, they’ll be moving around like a yo-yo in the interim. Daily swings of 2-3% aren’t uncommon.

This mix of volatility is hazardous to borrow against. All it takes is a few really bad patches to start the margin calls. I definitely don’t want to go back to that again.  The other possibility would be to have a strong core of Dividend Sloths. The slow moving, high yielders with low volatility like a Verizon or ATT. However I’m not really sure I want these in my portfolio unless they’re on sale.

No debt for debt’s sake

Much as I’d really like to get better near term tax efficiency, I’m not willing to trade that off anymore against the inflexibility of having a debt burden. Debt is  like having a stone around your neck. I’m really enjoying “pre FI” benefits. One of the main reasons that we are able to enjoy these is because our debt levels are pretty low. I know that we could a few asset disposals if we had to and be debt free.

The house will bring unavoidable extra debt, but it’s worth it for us for a lot of lifestyle reasons (the house that is…not the debt!).  I know there are a lot of folks in the finance blogging community that are in favor of maintaining long term mortgage debt, particularly at these low interest rates, and not rushing to pay it off. That makes a ton of economic sense from a tax efficiency perspective and also to to use cash resources to build income producing resources instead of paying off debt.

But I feel we’re at a point where I don’t really need or want additional income producing assets to be paid for with cash resources that could be used to pay off debt. The 401k will continue cranking along to produce steady gains. Our dividend assets in our taxable account will continue churning out increasing cash year after year. Our “soon to be” rental wlll also deliver a steady stream of income. Do we really need any more?

All I know is I’ll be putting our collective income streams to work like crazy to pay off this new mortgage, hopefully in a fraction of the time that it’s actually due.  I’m beginning to really warm to this financial independence thing. I don’t want to sabotage it by keeping any debt any longer than absolutely necessary.

Comments

  1. moneycone says:

    Owning a house with the dual purpose of living in it and and as an investment, in my opinion is better than renting. Considering the housing bubble just broke, this is a good time to own one.

    But a house can be a sink hole! Do consider that – there are a lot of expenses with home ownership. Research thoroughly and decide.

    • Integrator says:

      Good point. It’s not lost on me that the cost of housing repairs, taxes etc will likely be significant over time. I guess we have an innate desire to own assets rather than rent. The ownership and running repairs on the condo have been exceptionally manageable. It would be great if we could be as lucky with the house!

  2. FI,
    You are so close to paying off the condo, you might as well finish that off and rent it for great income.The bigger house will be a good living space and the debt on it won’t be too bad. Pay it off on your own pace. I’ve never regretted paying off a debt. Some people are very passionate about holding onto a mortgage for 30 years, but when you reach FI and quit working you won’t miss the mortgage, that is for sure.
    -RBD

    • Integrator says:

      RBD, We’ll definitely not be looking to muck around with the debt. I get the arguments for hanging onto cheap interest and investing into income producing or growth assets. I feel slightly nervous each time I look at our cumulative equity balance. I’m happy to just let that grow of it’s own accord, rather than investing significant excess into my taxable accounts. I think we’re at the stage where we don’t need significant equity inflow year in year out beyond the 401k max contribution. As rates start picking up, I may start looking at enhanced corporate bonds as another source of investment.

  3. I think RBD is on the right track. Pay off the condo, realize the additional cash flow from the rental, and pay off your new primary mortgage when and if you see fit. Given you have five years left till FI, the flexibility is all yours for the taking.

    • Integrator says:

      I’m looking forward to seeing how the rental works out as a source of cash flow…. it’s exciting and somewhat nervewracking at the same time as we’ve never been landlords before. It’s so much easier with equities and asset management. There’s no potentially uncomfortable tenant interactions.

  4. Steve says:

    Paying 3x in interest to save 1x in taxes doesn’t make sense unless you can earn better than 2x in income/growth from the cash. I refinanced at 3.5% for 30 years a year ago and invest the difference between that payment and a 15 year mortgage payment into an account at Betterment. I estimate I’ll be able to pay the place off (if I so choose) in 12-13 years with the funds in that account. Alternatively, that account could just be earmarked to continue to pay the mortgage.

    I prefer to invest in real estate through more liquid vehicles (REITs), I consider the house as a place to live, not an investment.

    • Integrator says:

      Steve, It’s an interesting question.
      Let’s say you took another $100k in debt, with a 6% interest rate. Your interest obligation is $6k, of which you’ll shelter say $2.5k due to savings on tax. If you can earn greater than the interest rate as a rate of return, say 10%, your cash outlay of $3.5k has netted you $10k in capital appreciation (putting aside any dividend you may have).
      Let’s further assume you are looking to redeem and cash out the return. your $10k, would be a long term capital gain if held for a year, meaning you pay $1.5k in taxes and net $8.5k. So your $3.5k initial cash outlay has netted you $8.5k net…. not a bad return ?!

  5. Mike says:

    Is HIMX on your radar?

    If so, any thoughts?

    • Integrator says:

      Hi Mike,

      In the semiconductor/chipset space, I more prefer Qualcomm exposure. Semi’s can be a volatile, fluctuating market. You can see that with HIMX revenue growth and dividend history. It’s not consistent and more than a little patchy. Qualcomm has much stronger IP in the space if you ask me.

  6. Great blog you have here integrator. I’m a huge proponent of real estate as an inflation hedge and for the tax breaks. One of my biggest rule of building wealth is make enough where taxes is your biggest expense but your lowest expenditure. Through maxing 401K deductions, credits, tax loss harvesting, offsetting real estate investments, etc. we aim to write off at least one salary.

    • Integrator says:

      Charles, I like it!. Wow, that’s a lot of interest expense to shield a full salary. There is an optimal amount of debt to carry in my view where debt coverage is still pretty comfortable and you can still shield some amount of tax expense. Tax leakage is often too neglected. We try and do too much to juice up our returns without thinking through how we can just invest more in the first place.

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