Is debt smart for your plan?

Intelligent borrowing, especially at today's low interest rates, can be a useful tactic.

30 Jun 2016

When most people think about their finances, they focus on assets—stocks, bonds, property and cash. But those represent only one side of a personal balance sheet. The other side—liabilities, or debt—is equally important. And while you need to keep your liabilities at a manageable level, strategic borrowing, particularly at today’s historically low interest rates, can be an essential part of your overall wealth management strategy.

Many investors consider it best to avoid debt entirely or to clear it as quickly as possible. That makes sense if you’re paying off a high-interest credit card balance. But other kinds of loans can help diversify and strengthen your balance sheet. Your Financial Advisor may know of various ways debt could actively help you purse your financial goals.

“Diversification is a useful framework for thinking about debt,” says Michael Crook, Head of Investment Planning at UBS CIO Wealth Management Research. Most investors have already embraced one form of debt as an instrument for building value, of course. “When you take out a mortgage to buy a home,” Crook says, “you’ve added equity in a house to the asset side of your personal balance sheet.” 

While each family’s situation is different, here are a few guidelines for using debt wisely.

Key takeaways

  • Smart use of debt is an important part of a well-balanced financial plan.
  • Use debt to diversify your assets, such as taking out a mortgage to purchase a home.
  • Analyze potential borrowing in the context of your complete financial plan to determine whether debt will help you achieve your financial goals.
  • Maintain control of debt by keeping enough cash on hand to pay liabilities and locking in long-term rates.
  • Review debt against changes in interest rates and your financial situation to potentially improve your positions.

Borrow to build value, not increase spending

There is a difference between using a credit card for discretionary purchases and taking advantage of other kinds of borrowing that could benefit your overall balance sheet.

You could take out a loan to pay for a child’s or grandchild’s education, boosting his or her future earning power. Or suppose you face a large tax bill. If you sell stock to come up with the money, that sale might trigger still more taxes on capital gains, and it might mean parting with shares that could increase in value. Instead of selling those investments and paying the additional taxes that sale would incur—while also losing the possibility of future earnings of those investments—you could consider borrowing and using those shares as collateral. Borrowing instead of selling means avoiding that additional tax hit, and keeping the possibility of the shares’ increasing in value in the future.

Borrowing to build or maintain a business can be another productive use of debt. You could use loan proceeds to address short-term cash-flow issues—to purchase new equipment, pay estimated taxes or make a payment to a vendor. Putting money from a loan to work in your company could increase the value of an asset that may account for a large proportion of your family’s wealth.

Manage debt proactively

Regularly reviewing your liabilities is part of the wealth-planning process, and may help you uncover opportunities to improve your balance sheet. Refinancing your mortgage to take advantage of lower interest rates is one obvious example. But changes in your financial situation could also have an impact. For example, if you receive an inheritance or finish paying your children’s college costs, you might decide to use the surplus cash either to pay down debt or to buy additional assets. Growth of your investment portfolio, meanwhile, increases the amount you can borrow with a securities-based loan, providing liquidity you could apply to your balance sheet wherever it would do the most good. Speak to your Financial Advisor about what would be best in the context of your larger wealth management plan.

Analyze the complete impact of any borrowing or repayment strategy

Before you decide to make a change to the liability side of your balance sheet—either by borrowing money or by paying off an existing loan—consider all the ways such a move could affect your personal balance sheet. There might be tax consequences or considerations about the cost of debt relative to potential investment returns. Your need for liquidity could be another factor.

Suppose you have cash on hand and could use it either to pay off your mortgage or to expand your investment portfolio. You might decide that it would be preferable to put the cash into new investments—expanding the asset side of your balance sheet, rather than decreasing its liabilities. The tax deduction for mortgage interest could also make keeping the home loan even more attractive. Or, you may decide to pay off your mortgage, eliminating what is probably your largest single debt, which has its own benefits, including freeing up cash for other purposes. Your Financial Advisor can analyze the variables associated with adding or reducing debt to help you determine what is most likely to help you achieve your other financial goals.

Be prepared to pay off your debt

If possible, maintain sufficient assets that you can easily convert into cash to retire your debt, particularly debt that is subject to “collateral call”: the possibility that the underlying collateral will drop in value. In some cases—for example, if you take a securities-based loan using your investment portfolio as collateral and its value declines—you could be required to deposit more funds into your account. And if you don’t have the money, you could be forced to sell some holdings, often just when they’re losing value.

For some debt, it can be useful to try to lock in the terms for as long as you plan to hold the loan or the asset you bought with its proceeds. If you expect to stay in your home indefinitely, for example, a 30-year fixed-rate mortgage could help you avoid the damage that rising interest rates could do to your balance sheet.

Your Financial Advisor is a great resource to help you manage debt decisions on an ongoing basis. For more details on how to incorporate borrowing decisions in a holistic wealth management strategy, download and read UBS’s Your Wealth & Life report “Leverage your balance sheet.