My dad tells this story about his Finance 101 class in college in the 1970’s. The finance professor walks up to the chalkboard and writes ‘O – P – M’. He points to the acronym with the chalk and circles it while telling his students that the first rule of finance is to use “Other People’s Money”.
My dad’s story does not translate perfectly to personal finance, but I think many investors would be better off treating their net worth as the balance sheet of a business.
Debt-free is not always the ideal situation. If you have the assets to pay it off, it’s not debt, it’s leverage.
Everyone has a different comfort level with leverage, but interest rates are low and likely to remain low for the foreseeable future. The balance sheet conversation is one worth having.
The world’s wealthiest families have always used leverage. This is the raison d’etre for private banks, whose entire business model is predicated on lending to wealthy clients while also managing their investment portfolios and their cash.
There are a million reasons to use both sides of the balance sheet, but here are a few examples to jog the imagination.
Are you delaying the realization of capital gains to pass stepped-up basis to the next generation? Borrow against the stock and let the dividends cover the payments.
Need a new house in Naples? Use a revolving line of credit against your investment portfolio (SBLOC – securities backed line of credit) to purchase it with cash. Pay monthly interest until you secure a fixed rate loan for 80% of the home’s value.
Expecting a large tax bill? Instead of selling securities and paying more capital gains tax, pull cash from your credit line. Maybe next year is a better year to realize capital gains.
Want to help your adult son purchase a new home? Use your investment portfolio as collateral, while your son and his wife list the loan on their credit record and make the payments.
Itching to become an angel investor for a talented your entrepreneur? Again, the securities backed line of credit is an easy way to access cash while waiting for liquidity, long-term capital gains treatment, bond maturities, or any other mismatch of cash flow within your financial ecosystem.
There are a few major caveats to what I am suggesting here. First, I am not recommending using margin to purchase additional stock or bond investments. While this type of leverage is used by hedge funds and institutional money managers, it introduces a level of volatility to a portfolio that can be dangerous. Margin calls are the second fastest way I know to lose money. What’s the first? Divorce.
Even if you’re not buying stocks with leverage, there is still risk involved when using your investment portfolio as collateral. When the market sells off, the value of your collateral falls, and you could face a decision to payoff part of the loan, sell securities, or add new collateral. It’s best to avoid this situation in the first place, by borrowing much less than the maximum amount available. TLDR: Don’t borrow too much.
Once you start to view your personal balance sheet as a business, you start to question where your capital is parked and why. Do you really need a ton of equity in your home, a slow growing asset? Would that money earn more in the stock market? Are you comfortable with how borrowing changes your monthly cash flow?
Do you really need a 30-year fixed rate mortgage? The average homeowner lives in their home for 7 years, and generally, the 7/1 ARM or 10/1 ARM (adjustable rate mortgages) are cheaper.
True story. I bought my house in 2014 with an adjustable rate mortgage fixed for 7 years. It wasn’t our forever home, and I expected rates would be higher when the rate adjusted. I figured the cost savings on the original rate would cover any higher payments I might make if we lived in the house a little longer. As it turns out, the rate is set to DECREASE this fall to 2.50%. I lucked out with interest rates, and I didn’t need to lock in that 30-year rate.
Getting comfortable with interest rate risk opens a new frontier for maximizing wealth. It allows investors to manage the timing of tax payments and provides greater flexibility of cash flow.
Like many decisions in personal finance, the black and white numerical answer is not always right for everyone. Rates of return, interest rates, and inflation are not known in advance. Leverage amplifies market movements both to the downside and to the upside. Managing both sides of the balance sheet requires careful coordination, skill, and additional risk management tools. But when done right, leverage can unlock the door to another dimension of potential wealth creation – one that is often overlooked or ignored.