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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: kgm on August 31, 2013, 11:03:54 AM

Title: when does cheap debt become expensive
Post by: kgm on August 31, 2013, 11:03:54 AM

In Feb 2008, we hatched the plan to retire in 2012, at age 47, at which point we felt we would move out of NJ because property taxes & health insurance costs are crazy.  The value of our property is a significant chunk of our total net worth, and selling does two things: gets us out from under the 7k (!) in property taxes, and frees up a lot of capital that can be used to produce more passive income.  Obviously the house does not work efficiently for us as an investment -- so we planned to cash out.  About 5 years ago we refinanced our remaining 210K mortgage as a home equity line at 2.75%.  Since that time we paid it down to a balance of 150K, then with the grand retirement plan we switched to simply paying the interest charges.  There were three factors leading to the decision: we earn more (avg 5-5.5% on our portfolio) on the invested 150K than we are paying in interest so there is a net positive +2.25% each month, the short-ish time horizon, and housing bubble bursting; we didn't want to sink even more of our entire net worth into the house/farm, preferring to have greater diversity in investments. 

Further info:
My husband retired last Dec about six months after we reached the magic cross-over point of passive income exceeding expenses.  I will follow this December, so we're only a year behind our FI plan despite the financial melt down.  FYI, we have no problem making the payments: we are about net on my single salary, and have budgeted for the cost savings once I stop commuting 70 miles per day and we switch to drawing rather than re-investing dividends.  The HELOC is our only debt, car owned outright and we pay credit card to zero every month after earning the cash back for using it.

With ACA, we feel our health insurance options in NJ will be much better, though probably not much cheaper.  Currently there are only about 4 private plans available, the least expensive pre-exchange is still massively expensive. 

Other factors are the two retired horses, who we made a commitment to and will honor until their natural lives end.  Since the grand plan to retire we've thought a lot about their upkeep.  There is no cheaper alternative than to maintain the farm where we produce the hay that feeds them.  Our carrying costs are a total of 100/month -- any other situation for them, based on research, would cost us minimum 250/month/horse.  The way we calculate, the approx 500/month we pay in taxes in NJ would be replaced by that amount in boarding fees if we moved elsewhere, possibly other costs for feed etc on top of that, plus we would have to replace the home and likely incur property taxes (albeit significantly less) if we move.  Both horses are almost 30 yrs old; probability is that they have around 5 yrs more, but there is no way of knowing.

We are also, the more we discuss and ponder, which is what we spend a lot of time doing, feeling like the staged approach to full time retirement & living situation is more comfortable for us.  We are willing to go outside our comfort zone but feel that both of us full-time retired will take a bit of getting used to; for DH he'll need to get used to having me around, and for me I'll need to acclimate to lack of schedule.  So a wholesale move to an new state, new town, new house, etc feels overwhelming.  And we have a circle of friends, love our community, love our farm, and have lots of amenities both bikeable or within very reasonalbe drive, all in a nice, temperate climate. 

Should we retire the HELOC?  If the variable rate rises, there is no question that we'll pay it off.  But as long as we have at least 1/2% net positive, DH feels we should keep on taking the +.  I keep feeling that over time the cumulative amount paid in debt service will errode the monthly net gains we enjoy.  It makes rational sense that if we make more on the invested capital than it costs us to carry the HELOC, then we should continue to do it.  But I keep thinking about the monthly expense and the open-ended time frame.  Remember we went into this debt-service-only scenario with the thought that we'd be out in 4 years, but are now realizing that we'll likely be here another 5 or so.  Paying off the HELOC means foregoing the compounded interest on 150k invested, but if we no longer have the debt payments, it reduces our monthly nut and those funds stay invested because we'll draw less of the dividend stream.  So over time that monthly reduction in draw from the portfolio, compounded, will surely equalize the lost income now, right?  I just don't have the math skills to figure out over what time period we could reasonably expect to regain the invested 150k.  There is still the issue of the overall portfolio balance and not wanting the additional 150k tied up in a single property, but that is maybe a different discussion. 

Can you folks offer a reality check?  Thanks in advance for input and wisdom!
Title: Re: when does cheap debt become expensive
Post by: gooki on August 31, 2013, 06:09:19 PM
It really is as simple as the interest rate on the heloc vs the expected ROI from your investments less any taxes.
Title: Re: when does cheap debt become expensive
Post by: Catbert on September 01, 2013, 04:01:28 PM
I would tend to not pay it off until interest rates rise.  When your retire will you be able to deduct your HELOC interest for Federal/State income tax purposes?  Or will the standard deduction be better?  (Or maybe its not deductible as acquisition debt any way.)  If its deductible then the part that's over your standard deduction, cost you even less than the 2.75%.
Title: Re: when does cheap debt become expensive
Post by: Catbert on September 01, 2013, 04:23:56 PM
Now that I've pondered this more I'm going to change my answer. When interest rates go up (no *if* about it) if you take 150K out of your portfolio what will the tax consequences be?  If IRA/401k then it will be taxed as "income" and taking out 150K will jack your marginal rate way up.  If from investment accounts then you'll owe capital gains which I *think*are 20% this year but 0% if your in the 15% income tax bracket.  If you have 150K in cash equivalents then you aren't getting 5% return on that portion of your portfolio.

Depending on these tax considerations it might make sense to pay it off over the next couple of years.  If you're not really familiar with taxes, it might make sense to visit a CPA and do some tax planning.  If did that in 2012 when I wanted to take capital gains at 0% to fill up my 15% bracket while trying not to screw up some other deductions which would phase out if MAGI was to high.