Market Watch : When Taking on More Debt Is a Smart Move

There’s no rest for the indebted.

Donald J. Trump must sell assets and secure more loans before additional payments come due next month or the boy billionaire will add another “b” word to his vocabulary--bankrupt.

Trump, of course, borrowed beyond his means--and he is certainly not alone.

The past five years, consumer and mortgage debt has increased 9.3% annually, while personal income has grown less than 5% a year. Today, the average American--man, woman and child--has borrowed nearly a full year’s income.

“Whether you are a small-time investor or a mega-investor like Donald Trump, if you don’t use debt wisely, you end up in trouble,” said Richard Martens, executive vice president of retail lending at Security Pacific National Bank.

Does that mean it’s time to stop borrowing altogether? Not necessarily.

Using other people’s money is still a good way to get rich. The trick is determining when borrowing will be profitable. Credit experts say there are a number of rules that borrowers can follow to determine when debt makes sense.

* Borrow when the cash generated by the investment is sufficient to cover the debt.

An example is the purchase of rental property whose rents will cover expenses related to the property’s purchase, with the exception of the down payment and closing costs.

“The first rule of thumb is every property needs to have cash flow even after taking into consideration the mortgage, taxes, insurance, repairs and potential vacancies,” said Richard L. Otterstrom, president of Coast Harbor Realty in Venice. “If you are not an experienced owner and manager, you should also pencil in the cost of outside management.”

Vacancy rates typically range from 5% to 10%, Otterstrom said.

Cash flow is a product of the size of the down payment and the kind of loan secured. Fixed-rate loans are more predictable, but adjustable-rate loans are often less expensive the first few years.

More significantly, the bigger the down payment, the better the cash flow. But, remember, that money is tied up in a long-term, non-interest-bearing investment. Consumers must weigh the benefits of generating even better cash flow against the loss of the use of that money. Generally, investors shouldn’t put more down than required to create break-even monthly cash flow because excess cash can be better spent elsewhere.

* Borrow when money is cheap.

In inflationary times, it makes sense to borrow because the loan will be paid off with cheaper, inflated dollars. In the meantime, those funds could be invested in higher-yielding securities.

Even when inflation is not an issue, people can sometimes earn money by borrowing and investing the funds at a profit.

“Deferred” wages are one such opportunity. Some companies allow their workers to lend the corporation cash by deferring part of that year’s salary. To encourage this, the company often pays the worker an amount equivalent to its borrowing costs--prime plus 1%, for example. At today’s rates, that amounts to 11%. If the employee can borrow elsewhere at a lower rate--possibly through a home equity loan--the transaction can earn handsome rewards with little risk.

* Borrow when your monthly income is sufficient to cover the debt and the money can be used to create greater value.

This is, perhaps, the trickiest rule because what looks like a sure thing doesn’t always pan out. And some people are able to justify virtually any expense with an argument that it will produce a potentially lucrative reward.

It is easy to justify borrowing to buy a car when it is the only reliable form of transportation to get to work. But does it make sense to go into debt to buy an $80,000 Mercedes? Most financial advisers would say no. But there are exceptions. A few professionals might argue that, to be successful, they must have some trappings of success.

* Borrow to build equity.

It often makes sense to borrow to buy a first home or fix one up. First-time home buyers not only save money on rent, they also gain tax benefits and build equity.

Generally, mortgage lenders say a house payment should not exceed 30% to 40% of the borrower’s gross monthly income.

Spending on remodeling can be rewarding. The rule of thumb is: Spend if improvements will be worth $2--when the home is resold--for every $1 invested. Home-improvement publications often list the kinds of additions and remodeling projects that are most likely to pay off.

* Borrow when the money is free.

You’re in a department store about to make a purchase. Do you write a check from your interest-bearing checking account, or borrow by putting the purchase on a store credit card?

If the store allows a grace period for payments, borrowing makes sense because the debt is free. Also, stores often have promotions where they’ll extend the grace period.

Earnings on the “float” are small, of course.

The debt should be paid before the grace period expires, however, because most department stores charge upward of 19% for credit.

* Don’t borrow when monthly payments exceed your ability to pay with your monthly salary, without overtime. When you need more than your monthly salary to pay debts, you are clearly overextended.

* Don’t borrow long term at high, short-term rates. In other words, don’t keep a high monthly balance on credit cards when you could refinance that balance through a less-expensive home-equity loan.

* When you have insufficient cash flow, don’t borrow on equity.

Californians often borrow against equity in real estate, sometimes with the intention of “turning” properties--reselling them quickly--or developing them.

This may not make sense in today’s slower real estate environment. Not only have home prices stopped rising rapidly, the amount of time required to sell one has increased considerably.