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Personal Loan or HELOC, or "Why No Low-Interest Debt?"

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  • Personal Loan or HELOC, or "Why No Low-Interest Debt?"



    My wife and I are a two-physician family in our mid-40s and live modestly, but after 10 years in our house, it's finally time to renovate our kitchen and lower level. I’ve listened to the WCI podcast and read the blogs regularly for some time now, and your advice is sound and informative, but I confess I don’t understand the aversion to low-interest debt. Mathematically, the opportunity cost of missing investment gains at an average of 8-10%, compounded annually, seems too high to justify using extra money to pay down low-interest debt. For example, we haven’t been in any hurry to pay off my wife’s med school loans or our mortgage, both at 4%, as we’ve been able to grow our personal wealth significantly by investing in index funds in tax-free, tax-deferred, and taxable accounts over the past 10 years.

    My question is, what about a HELOC or personal loan to finance our kitchen remodel? We could pay for it by selling funds from our taxable account, with a 15% long-term capital gains tax penalty, and losing 10-20 years of compounded investment interest on $75-$100 K (a potential loss of up to $450K). Or, we could secure a loan for around 5%, using as collateral our home equity (HELOC) or taxable investments we were going to cash in anyway (personal loan), realize a tax deduction with the HELOC (still deductible for home improvement based on IRS guidance on the new tax law), and continue to grow our personal wealth.

    As I mentioned, we spend modestly ("one house, one spouse, one job"); have no high-interest debt (i.e., credit card) or luxury hobbies (economy cars, no boat); maximize contributions to our 401a, 403b, and 457b employer plans and back door Roth IRA; and also contribute frequently to our son's 529 plan and our joint taxable investment account. Our cash flow is also fine and can tolerate the addition of a new monthly payment.

    So...is there any reason not to go for a HELOC or personal loan?


    Thanks!

  • #2
    Look at it this way. You are considering taking on debt in order to maximize your exposure to the market (and the risk that comes with it). In the booming market of the past decade, that strategy would have served you very well (retrospect). However, if the market were flat or down over the past few years instead, you would have come out ahead by paying down your loans instead of maximizing market exposure. No way to predict which strategy will prevail in the future.

    Maybe another strategy to consider is to just use your cash flow for the project.

    Comment


    • #3
      It's true, no one can predict the future, but best guess based on 90+ years of data is that the market gains, on average, 8-10% per year. We must assume long-term gains to guide our behavior; otherwise, what's the point of investing? Even if we had transiently posted losses over the past 10 years, it still would have been a better decision to invest that money for the long-term future (30+ years), albeit with a gradually decreasing allocation of equities (i.e., 90% down to 50% around the age of retirement).

      Comment


      • #4





        For example, we haven’t been in any hurry to pay off my wife’s med school loans or our mortgage, both at 4%, as we’ve been able to grow our personal wealth significantly by investing in index funds in tax-free, tax-deferred, and taxable accounts over the past 10 years.


        Click to expand...


        There it is, right there.  It's starting to feel like it is impossible to lose money in the market because of how long this bull has run.  Equities should outperform 4% loans over 10+ year timeframes, but you never know if it is better over shorter periods.

        I like the above recommendation to pay for it out of cashflow.

        Comment


        • #5
          Well, same answer. I use the past 10 years as an example, but I view all of our investments as long term, recognizing that there will be bull and bear markets over shorter terms. That still doesn’t seem to be a reason not to invest.

          Separately, we haven’t kept $75-$100 K reserved in cash, preferring instead to put these funds to work.

          Comment


          • #6
            Based on the original post and your responses, it sounds like you clearly want to fund this with a loan. If that's the case, go for it, you'll be fine.

            Best case scenario, you'll get a few percentage points of interest arbitrage on $75k for a few years, which will amount to very little. Or you could come out behind.

            Comment


            • #7
              I'll chime in although I can tell your mind is basically made up. If you truly feel that you're better off taking out a HELOC or personal loan so you can put that money into the market instead of into your renovation, that basically means you feel comfortable taking out a loan and then putting that money into the market. Are you trying to take out as much money as you can on loans to put into the market since it's such an easy win? I bet you aren't.

               

              It shouldn't take long for a two physician household who lives modestly to be able to cash flow this project.

              Comment


              • #8
                No, my mind’s not made up at all; I’m just playing devil’s advocate to all of the anti-loan advice. I’ve gone back and forth in my thinking about 4 times.

                Part of my thinking is that the “few interest points arbitrage” presumption ignores the long-term effect of interest compounding. A $100K loan at 5% costs $58K over 20 years. A $100K investment at 8% yields $366K over 20 years. That’s a considerable difference!

                Comment


                • #9




                  No, my mind’s not made up at all; I’m just playing devil’s advocate to all of the anti-loan advice. I’ve gone back and forth in my thinking about 4 times.

                  Part of my thinking is that the “few interest points arbitrage” presumption ignores the long-term effect of interest compounding. A $100K loan at 5% costs $58K over 20 years. A $100K investment at 8% yields $366K over 20 years. That’s a considerable difference!
                  Click to expand...


                  Are you really considering paying your renovation off over 20 years?! You should be able to cash flow that easily in a year or two. That nullifies your assumption completely and that doesn't even take into account that you're not really comparing apples to apples. Sure, the stock market is likely going to go up over a period of 20 years or so but who knows what it's going to do over the next year or two. The market could have a net return of <5% which makes paying for the renovation in cash the better bet, assuming that's about what your rate will be. That's why the comment was made about the few interest points arbitrage. That's exactly what it may end up being over the next year or two, at best.

                  Comment


                  • #10
                    You can have this argument all day long without a clear winner unless both sides can predict the future.  We recently did a renovation, all cash, and went through the same thought process.  In the end, we decided that at the point we are with our investments now, we will be fine in the future even without leveraging ourselves further, and we would rather draw a line in the sand and not take out any more loans, esp. for non-income producing assets.   At the time we started thinking about the renovation, we did not have enough in cash to pay for the whole thing (had enough in our taxable accounts but didn't want to take it out).  It took us over a year to plan out what we wanted to do, hire an architect, hire a contractor, and then another 6 months to complete the project.  During that time frame we continued to fill all our tax-advantaged investments, but decreased the amount we invested in our taxable account to be able to cash flow the whole thing.  It was painless, and now it's done and paid for, which feels good.  It also cements the habit of not taking out loans for "extras".

                    A few other advantages:

                    1.  Saves on reno costs directly.  If you get a loan, there will be other associated expenses.  They are relatively minor, but a few thousand saved is a few thousand.

                    2.  Saves on time associated with taking out a loan.

                    3.  Saves in reno costs indirectly.  If you have a budget of 150k and are paying with cash, you are much more motivated to stay within that amount IMO.  So many people told us that we would go way over our reno budget because everyone does.  Nope.  We told our contractor that we were paying cash and needed to stay within the proposed budget and it happened.  Part of this was finding a good contractor, but part of it was not changing to more expensive choices throughout the project.  It is really really easy for a project to spiral out of control budget wise.  It's easier to say no when you are paying cash--and easier for the contractor to understand "no" when they know you are paying cash.

                    BTW, unless you have a lot of experience and really know pricing, expect your project to cost more than what you originally expected.  Architects do not know how much things are going to cost.  Consider using a design/build team rather than a separate architect and contractor.  And look at different options/ask questions--there are often several ways to achieve the desired objective, and some ways will be less costly than others--sometimes the architect draws something up and you don't ask questions about it and just go with it when there could of been a better way.  It helps if you have friends who are structural engineers or have construction experience to guide you with the right questions to ask--we know nothing about construction but have friends who do which helped a lot.

                    Good luck!

                    Comment


                    • #11
                      lol this thread again (no offense to OP, more to the inherent basis of the question).

                      Short answer: Take the HELOC. Its a good move.

                      Long(ish) answer: Well, this community isn't built for leverage. Check the ads, what do you see? Refi Debt, manage debt, get rid of debt. Its simple approach to reach your destination. Try posting this question on boglehead, see what you get. Point being, math works, the psychology doesn't for majority here (this is not a good or bad thing, its just a thing)

                      You can extend the same argument to something like this (since you are mathematically inclined and want to be efficient doing it):

                      - Why not use reasonable leverage to buy stocks, like all the time. Specially when you are young? Run MC and you'll see you are ahead.

                      - Why use bonds at all? Just go 100% stock all the time. Your portfolio at X age would be so large, you can take swings.

                      - Why not invest in PE? or small business? Do franchise - 30% return. Beats the market. Who cares about the market.

                      -  Momentum trading works, set up an algorithm to play swings and you'll be making money.

                      .

                      .

                      Not being facetious. They are true. I have/am doing those. Can you stay the course? Execute it? Life would be complicated? Stress? Those are the questions you need to ask. It'll come from within rather than on this forum. "Personal" finance yo.

                      Comment


                      • #12
                        Some points to consider:

                        • You are overstating likely returns after a phenomenal nine (9) year+ bull market and not considering a likely reversion to the mean. Most projections are for more like 6% equity returns moving forward.

                        • You have not included tax drag. You don't receive nominal returns. You receive net returns after taxes.

                        • 20 year net returns are close to 6.5% total stock market and 4% total bond market

                        • You are using market returns and not portfolio returns.

                        • An 80:20 portfolio has had 20 year net returns ~= 6%.

                        • The prime rate is 4.75% and the Fed has plans for two more rate hikes this year. They will also likely be 0.25% hikes. HELOCs are usually Prime + (0% - 1.25%). You might be able to get a 1-year teaser rate < 4%, but it would likely be 5% - 6% in a year or two.


                        I am not one of those people who think all debt is bad. I think there is good debt and bad debt. There are those who categorically say you should never get a car loan. To me it would have been counter-productive to forgo a 1.49% loan for my last car.

                        There are many people with both mortgages and student loans ~= 3%. I see no reason to pay those off early, but I would personally be aggressively in paying down a 4% student loan.

                        I certainly wouldn't be taking out a 5% - 6% HELOC for a voluntary expenditure. I would wait until I had the cash available.

                         

                         

                        Comment


                        • #13




                          Some points to consider:

                          • You are overstating likely returns after a phenomenal nine (9) year+ bull market and not considering a likely reversion to the mean. Most projections are for more like 6% equity returns moving forward.

                          • You have not included tax drag. You don’t receive nominal returns. You receive net returns after taxes.

                          • 20 year net returns are close to 6.5% total stock market and 4% total bond market

                          • You are using market returns and not portfolio returns.

                          • An 80:20 portfolio has had 20 year net returns ~= 6%.

                          • The prime rate is 4.75% and the Fed has plans for two more rate hikes this year. They will also likely be 0.25% hikes. HELOCs are usually Prime + (0% – 1.25%). You might be able to get a 1-year teaser rate < 4%, but it would likely be 5% – 6% in a year or two.


                          I am not one of those people who think all debt is bad. I think there is good debt and bad debt. There are those who categorically say you should never get a car loan. To me it would have been counter-productive to forgo a 1.49% loan for my last car.

                          There are many people with both mortgages and student loans ~= 3%. I see no reason to pay those off early, but I would personally be aggressively in paying down a 4% student loan.

                          I certainly wouldn’t be taking out a 5% – 6% HELOC for a voluntary expenditure. I would wait until I had the cash available.

                           

                           
                          Click to expand...


                          Prime rate is a great comment here. Leverage is NOT as attractive as it was few months ago.

                          Comment


                          • #14
                            Great points from all, and they help unpack some of the complexity of this decision. I'm all for keeping life simple, but am willing to generate some complexity for more long-term wealth, if it makes sense. We do have a design/build team, and they have been very conscientious and cost-conscious, having already suggested a few ideas we hadn't considered that will end up saving us more in the end. The point about the slippery slope of leverage is also well taken. I agree that the 8-10% return I stated was market and not portfolio, although our portfolio is currently 90:10, but it's true that the prime rate has been rising and will probably continue to do so.

                            Comment


                            • #15




                              Look at it this way. You are considering taking on debt in order to maximize your exposure to the market (and the risk that comes with it). In the booming market of the past decade, that strategy would have served you very well (retrospect). However, if the market were flat or down over the past few years instead, you would have come out ahead by paying down your loans instead of maximizing market exposure. No way to predict which strategy will prevail in the future.

                              Maybe another strategy to consider is to just use your cash flow for the project.
                              Click to expand...


                              They explicitly are looking long term, 20-30 years. Everyone that assesses these decisions on the day to month to couple year time frame is doing it wrong and its just a justification for whatever path you took. None of these decisions should be assessed on the shorter term, ie, when you'll actually drawdown the other account. If the draw down is soon, then that changes the better choice drastically. If its 20+ years, this will make sense and be a good probability move.

                              That doesnt apply specifically to the above case but the general. Things are definitely changing, not that itd be a bad move, but the odds arent as favorable as they had been the last couple years. Rates were probably artificially depressed by far too dire economic predictions that kept them lower than the macro situation suggested. I wouldnt take a tax hit to do it, but I'd also not want anything in the 5% range or on a variable rate.

                              Comment

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