The Pros and Cons of Borrowing - What’s in Your Best Interest?

October 4, 2013

Piggy BankIn a utopian financial plan, no one borrows money, because everyone has enough. Large items, like cars and homes, are paid for in cash and the word debt is never spoken, but that’s utopia. 

In real life, borrowing is almost inevitable, simply because most of us begin our financial lives with very little money. We have immediate needs, for things like transportation and housing, and haven’t had the time to accumulate enough savings to pay for them. So, we borrow, paying the lender interest for the opportunity of having something now.

Not only does borrowing allow us to make these purchases, but it also provides for the opportunity to use it in your favor. Using assets to generate a return that exceeds the cost of borrowing and taking a loan without having to liquidate another moneymaking asset is the basis of “leveraging”, a strategy that allows individuals to increase their personal wealth through the use of OPM – other people’s money.

For both the necessary reasons and the prudent ones, borrowing plays an important role in many of our lives. Of course, for good and bad, this attracts the interest of government, specifically in regard to taxation. In the “good old days,” all interest was tax-deductible – even credit card interest on personal purchases. Then, Congress started differentiating between types of interest and things started to get complicated. Thus, it is vital to understand the tax ramifications of different kinds of borrowing.

The following is a quick summary of when you get a tax break for borrowing, and when you don’t.

Home-Mortgage Interest - You are allowed an itemized deduction for interest paid on up to $1 million worth of mortgages used to acquire or improve your primary personal residence and secondary home. Mortgage interest on your third home and beyond is considered a nondeductible personal expense. (Obviously, this ruling encourages you to pay cash for your third or fourth residence, although it’s unlikely that this is an issue most of us have to consider.)

Vacation Homes - For most people, the vacation home is the second home, and the mortgage interest will be deductible under the previously discussed criteria. However, if you rent the vacation home part of the time, the rules get very tricky. Usually, you will still be able to deduct most of the interest, but this is a calculation that requires extensive study or expert assistance.

Investment Interest - When you borrow money and use the proceeds to buy taxable investment assets, the resulting interest is called investment –interest expense (catchy title, eh?). You can deduct investment interest to the extent of your taxable investment income – from interest, dividends, short-term capital gains, certain royalties etc... If you don’t have enough investment income to offset the interest costs in a particular year, the excess interest can be carried over to the following tax year. This carryover provision can be exercised until all interest cost have been offset by investment gains. (You can also use long-term capital gains as part of your offset, but because long-term capital gains have favorable tax rates, the deduction may not be as desirable.

College Loan Interest - Congress has also given limited deductions for the interest incurred on college loans. The deductibility depends on your income level – the more you earn, the less interest you can deduct. For some, a home-equity loan used for education may be fully deductible while a student loan may not.

Interest on 401(k) Loans - This interest is never deductible. In addition, since you pay the loan back with after-tax dollars, which will be taxed again when eventually withdrawn, you might say the tax cost ultimately increases the cost of borrowing.

Interest on Car Loans, Credit Cards and other “Consumer Debt” - Unless the borrowing is for business purposes – like a vehicle used exclusively for business, or a computer for your office – you can forget taking a deduction.

This is why banks are so insistent in advertising home-equity loans. Compared to credit cards, car loans, and other similar installment debt, home equity loans have two distinct advantages. First, since the loan is collateralized by the home, the interest rate is often lower. Second, the interest is usually deductible. That’s a one-two punch that dramatically lowers the cost of borrowing. If you have credit card balances, automobile loans or other unsecured consumer debt, a home-equity loan to “exchange” that debt should be a consideration.

Business Interest - When you borrow personally to finance your business, the interest is generally fully deductible. However, be aware that the IRS has a complicated set of regulations that require you to provide a paper trail connecting all debt proceeds to business activity.

Even from this basic overview, several items should be apparent. How you borrow money can have a significant financial impact, not only because of the interest rate you will pay, but also because of the tax treatment of the interest. Like anything else that involves tax regulations, the process of determining the tax consequences can be complicated. But don’t let the complexity keep you from assessing ways to use debt to your advantage. All debt is not the same, and taking the time to get good advice and planning to borrow prudently is always in your best interest.