Debt and Taxes, Part 1

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Greece is again in the news, finally passing reforms that will probably enable them to receive the second round of bailout funds. Although they gave in to most of the IMF’s and the Eurozone’s (i.e., Germany’s) demands, even after this round of funding, it won’t be the end of the crisis for Greece or the rest of the PIIGS (Portugal, Italy, Ireland, and Spain). But the loans will buy time while everyone continues to prepare for the possibility that Greece leaves the Eurozone (I give it 50/50 odds). In the meantime, the ECB continues to shower the banks with liquidity, Portugal struggles to avoid Greece’s fate, Ireland is recovering nicely, and the big boys—Italy and Spain—make slow but steady progress. I predict the Euro experiment will eventually be declared a success, but not without a few more years of pain on the Continent.

Unlike last year, the financial markets currently appear to be taking all this in stride. The ECB’s massive $650 billion liquidity injection (the LTRO) has certainly helped, as has better than expected economic and employment news, both here and abroad. While we still have a long way to go until the global economy reaches normalcy (whatever that looks like), loose monetary policy by central banks around the world, coupled with governments that seem to have finally become serious about deficit reduction, is helping put a floor under stock prices (and a ceiling over interest rates).

Don’t fight the trend: the financial elite are doing everything they can to make “risk” assets enticing and “safe” ones unattractive. Ten-year US Treasuries at 1.98%? That’s -1.53% after taxes and inflation: $100,000 shrinks to $85,725 after 10 years at this rate. Instead, try a high-yield bond fund. At a current yield of 6.86%, JNK (SPDR Barclay’s High Yield ETF) turns $100,000 into $115,333 after taxes and inflation, a difference of $29,608 or nearly 30%. Better yet, put JNK (or a similar fund) in your IRA or pension account and have $144,470 after 10 years. (All this assumes no change in interest rates or inflation over the next decade.)

Stocks, many yielding well north of 3% (Pfizer currently pays 4.2%, and even Intel yields 3.1%), offer the prospect of rising dividends and rising prices over time, both at a rate that has historically outpaced inflation. You want certainty? Nothing’s certain in finance except debt and taxes—both of which will still be with us long after we’ve developed the technology to cheat death—and about which I’ll be devoting the rest of this newsletter.

How to make debt and taxes your friend (and let inflation work for you, too)

Greece is a perfect example of how not to use debt: they borrowed above their means and never established a clear path to service it, let alone pay it off. Many individuals have ended up in the same boat, borrowing more than they could afford and having to negotiate reduced payments or even losing their homes and/or filing for bankruptcy. While we have all heard ad nauseum how debt can get you into trouble, we rarely hear about the flip side: how to use debt to your advantage.

As you know, there are individuals and groups who are philosophically opposed to debt. But where would we be without the ability to lend and borrow money? How many people do you know who could afford to buy homes, not to mention cars and quite a few other things? And most companies could never buy the factories and equipment they need to make the products we find essential, including the generation of electricity. While unlike taxes, you have the option of avoiding debt, doing so is only rarely the shortest path to wealth.

Aside from the ability to purchase big-ticket items you otherwise couldn’t afford, the creative use of debt enables you to use both the US tax code and inflation to your advantage. How? In many cases interest is deductible, reducing your taxes and increasing your cash flow. As for inflation, while it increases the cost and value of most items, it decreases the cost of debt over time.

For example, at 3% inflation, a $500,000 mortgage, even if you don’t pay down a penny, is only worth $200,505 by the end of its 30-year term, and a $2,000 monthly payment falls to $802. During that same period, the equity in your $750,000 home would increase from $250,000 to $549,495, even if your home’s value merely kept pace with inflation. The magic of leverage + inflation has enabled you to double your home equity even with zero real appreciation of your home and zero payment of principal. And all the while, you’ve deducted the interest from your taxes.

This is why I’ll probably never pay off my mortgage, even when I’m 90 years old. Inflation doesn’t stop when you retire. So long as you’ve managed your debt and cash flow properly (something I emphasize with my clients), a mortgage is not a burden. Such is particularly the case now, with interest rates at historic lows.

Creative use of mortgage debt can also involve “equity stripping,” where you refinance your home and take out additional equity to invest elsewhere. How much more you take out, your ability to support the monthly payments, where you invest that cash, what kind of mortgage to use, and the current level of interest rates are just a few of the factors you need to consider when doing this. And don’t try this by yourself! Unless you’re a financial professional, you need a qualified advisor to guide you through the process and make sure you don’t end up like Greece.

Lots of people got into trouble doing just what I describe above. Why? Because most of them “invested” their money in additional real estate or even worse, cars, vacations and big screen TV’s. Using your home as an ATM rather than as an investment asset is one of the best ways I know to end up as a renter rather than a homeowner!

Other forms of debt can also be your friend, such as business loans, auto loans, student loans, and occasionally even personal or credit card loans. The best loans obviously have the lowest interest rate, but also have predictable payments (i.e., no surprise resets), are properly matched to their purpose, and have tax-deductible interest. (Every time the tax code is revised, the latter seems to become increasingly scarce.)

One other creative use of debt I’ll mention is the funding of pension plans. Many of us would like to save more for retirement but don’t have enough extra cash flow. With the proper use of debt, you can significantly increase your retirement nest egg and save a bunch in taxes at the same time. Again, this is not a do-it-yourself project, as there are lots of potential pitfalls.

In our blog (http://www.kenfieldcapital.com/blog/), we’re currently writing about the creative use of debt, with several specific examples. I invite you to peruse the articles and ask questions about the strategies. With interest rates at their lowest ever and both taxes and inflation likely to be on the increase in future years, now is the best time in history to take on a prudent amount debt. Of course, lenders remain stingy, and these strategies are likely to be of most benefit to those who really don’t need to borrow more. So while the rich continue to get richer, this is one case where the smart can get richer, too.

Make debt, taxes and inflation work for you! I know I am.

Dr. Ken Waltzer MD, MPH, AIF, CFA
Founder and President – Kenfield Capital Strategies (KCS)

Kenfield Capital Strategies™ (KCS) is an SEC-registered investment adviser. Our services include discretionary management of individual and institutional investment accounts, along with comprehensive financial, estate and tax planning services.