Lesser of Two Evils: Cost of Taxes vs Cost of Interest
If you're looking to finance a major purchase, you're likely weighing the options of either borrowing money or dipping into your savings. But what exactly are the costs associated with each choice? When it comes to borrowing, interest rates can be a major factor. And if you choose to sell investments to fund your purchase, taxes and opportunity cost come into play. While it can feel overwhelming to navigate all these different costs, we're here to break it down for you and help you make an informed decision.
The Cost of Borrowing
When you borrow money, you agree to pay interest on the amount you borrow. Interest rates can vary widely depending on the type of loan, the lender, and your credit score. As of April 2023, the average interest rate on a 30-year fixed mortgage in the United States is around 6.5%. Auto loans typically have higher interest rates, ranging from 4% to 10%. Personal loans, which are unsecured loans, can have interest rates as high as 36%.
Let's say you want to buy a 500k home, that requires a down payment of 100k. Assume you can borrow against your savings and investments, up to the 100k down payment required, and that the interest current interest rate, as of April 2023, is 8%. Your annual interest payments, before principal, would be 8k - every year. This is the cost of borrowing in this scenario.
Note how borrowing can also impact your personal cash flow. By borrowing against your investments, your loan might require principal and/or interest payments. If cash flow easily permits this additional monthly cost, then the risk of this strategy is lower. Alternatively, if cash flow is tight, any future emergency expenses could put an investor at risk of default on this loan.
Considerations should also be made to the loan type and duration. Is the interest fixed or variable? Are rates expected to increase or decline over the next few years? If the loan is variable, this presents a potential risk and opportunity – if rates increase then your cost to borrow increases, alternatively if rates decline your costs could go down.
The Cost of Taxes
When you sell an investment, such as stocks, bonds, or real estate, you may be subject to capital gains taxes. Capital gains taxes are based on the difference between the purchase price and the sale price of the investment. The tax rate varies depending on how long you held the investment and your income level.
In the United States, the tax rate on long-term capital gains (investments held for more than a year) ranges from 0% to 20%, depending on your income level. Short-term capital gains (investments held for a year or less) are taxed as ordinary income, which means you could pay up to 37% in federal taxes.
Using the same example above, let’s say that you could liquidate 100k from savings & investments and that your cost basis was 50k which leaves a capital gain of 50k. If you sell the stock now, you will have a capital gain of $50,000, and depending on your income level, you could owe up to $10,000 in one-time federal taxes. This is the cost of taxes in this scenario.
Investors can incorporate tax strategies to reduce the amount of taxable gains from selling their investments, such as tax loss harvesting or making charitable contributions. Depending on the investors’ situation, you might be able to eliminate the tax burden from this transaction all together.
Comparing the Two Costs
Overall, when making a decision about whether to sell investments or take out a loan, it's important to consider both the cost of borrowing, taxes and the potential opportunity cost of missing out on investment returns. This can be a complex decision, and it's important to consult with a financial advisor to determine the best option for your individual situation.
Comparing the cost of taxes to the cost of interest in this scenario, you would need to consider the long-term impact of each option. If you choose to sell your investments and pay the capital gains tax, you would reduce your investment portfolio and potentially miss out on future growth and returns. However, if you choose to borrow against your investments, you would incur interest costs until that loan is repaid.
Assuming a current interest rate of 8%, borrowing $100,000 would result in annual interest payments of $8,000. If it took you 5 years to repay the loan, you would end up paying $40,000 in interest costs. In this example, the interest costs would be 4x higher than the cost of taxes ($10,000 one time) over the 5 years. This is a significant cost to consider, but it may be worth it if you believe that the returns on your investments will be greater than the interest rate on the loan.
So which option is better? It depends on several factors, including your risk tolerance, investment goals, and financial situation. Investing in the stock market has the potential for higher returns, but it also comes with higher risks. Some investors might not be confident that their investments will outperform the interest they pay on the loan, while others can be very bullish on their investments. Taking out a loan allows you to buy a house, but the lifetime cost of borrowing needs to be considered. Many investors do not have the appetite for increasing their debt obligations, while others are comfortable taking on debt to keep money invested.
It's important to carefully consider all options and factors before making a decision. We recommend meeting with a financial planner to discuss your unique situation, risk tolerance, appetite for debt, etc.
What About Opportunity Cost?
Opportunity cost refers to the potential benefit or profit that you may miss out on by choosing one option over another. In the case of selling your investments to pay for a large purchase like a house, you would be sacrificing the potential growth and returns of those investments in the future.
To incorporate opportunity costs into the comparison between selling investments and borrowing, you would need to consider the expected rate of return of your investments compared to the interest rate on the loan. If the expected rate of return on your investments (net of taxes) is higher than the interest rate on the loan, then it may be more beneficial to keep your investments and take out a loan instead of selling them.
In our example above, you would need to compare the 8% loan interest with the expected market return on your investments – which is often impossible to predict. If you do not believe the market will produce 8%+ returns, then opportunity cost would not be present.
Alternatively, if the cost of borrowing is dramatically lower than the expected return on investments, then an investor might be better off borrowing and allowing their portfolio to continue to grow. For example, if the cost of borrowing is 3% while the expected return on the portfolio is 8%, then there is a 5% improvement by allowing the dollars to remain invested and borrowing against the portfolio to make the down payment.
In closing, when making a decision about whether to sell investments or take out a loan, it's important to consider both the cost of borrowing, taxes and the potential opportunity cost of missing out on investment returns. This can be a complex decision, and it's important to consult with a financial advisor to determine the best option for your individual situation.
DISCLOSURES:
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
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The information contained above is for illustrative purposes only. The above targets are estimates based on certain assumptions and analysis made by the advisor. There is no guarantee that the estimates will be achieved.
Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.
