Good and Bad Debt & Margin Debt
Good and Bad Debt & Margin Debt
There is good debt and bad debt. Even the IRS agrees: mortgage, business, and student debt are deductible, while credit card, personal lines of credit, and margin debt are not. (An aside: there is an option to offset investment income against margin interest, but then the character of all your investment gains changes to income — i.e. long-term capital gains and dividends will lose their special tax status and be taxed at your marginal rate.) I suppose there are reasonable reasons to favor one type of debt over another — the government wants to encourage home ownership, entrepreneurship, and education but not speculation or excessive spending.
There are good and bad debt — but the analysis is not as easy as saying one type of debt is “bad” and another is “good”. Mortgage debt is in not necessarily a good type of debt — many people take on too much debt and do not appreciate the risk of newer mortgage products. For example, Option ARMs — a mortgage with a teaser rate that allows people to buy more than they can afford — have a lot of built-in interest rate risk.
On the opposite end of the spectrum, credit card or margin debt is not necessarily bad debt. You can use either to leverage your investments. For example, some fixed rate credit cards are offered way below my current estimated cost of capital of roughly 6-8%. If I can borrow at a fixed rate below my cost of capital, I am adding long-term value.
With margin borrowing (or variable rate credit cards) you are also taking on interest rate risk and if interest rates increase, the value of your investment can decrease at the same time your borrowing costs increase. Still, especially with margin borrowing, you can significantly leverage your investments and increase value to your portfolio.
The most important problems people encounter when they use margin are: they over-leverage, they leverage the wrong investments, and they don’t manage their cash flows. The first, and most common, problem is that people leverage their portfolio to the hilt so that even a small an adverse price movement can mean liquidating part of your portfolio.
The normal person who uses margin is a risk-taker, the same sort of person who wants to invest in the next big thing. But, if you invest in more conservative run companies, with large dividend payments and low P/E ratios, you should not have as much price risk in your portfolio and will reduce your chance of a margin call.
It also helps your chances if you have positive cash flow to devote to your portfolio when the inevitable price declines come. If you are adding cash to your portfolio, there will have to be a much bigger decline in value before you need to liquidate.
I have learned most of these lessons the hard way. Now, I currently use a reasonable level of margin on more conservative investments and make sure that I have positive cash flow to devote to my portfolio when the value of my portfolio decreases. This does not guarantee that I will not have a margin call down the road, but it definitely decreases my chances while still increasing my returns.
Although most people’s goal is to become debt-free, debt can be a powerful way to increase your returns. As long as you are responsible in managing your risk, margin debt and other “bad” debt can be a good way to leverage yourself and create long-term value. However, if you are not responsible managing your risk, taking out any debt — even to purchase a home — can be disastrous.
(Disclaimer: I am not a tax advisor, so do not rely on statements contained herein — consult a tax advisor before filing. I try to be as accurate as possible but there are no guarantees.)
