A reader writes in, asking:
“I currently have a variable home equity line of credit (now at a 4% interest rate). We’ve currently borrowed $150,000 on the HELOC. We have about $850K in investments, mostly with Vanguard. How do I decide whether to pay off the loan, dropping my investments to $700K, when it seems I make about 5% on the investments?”
One way to look at the situation is that you’re simultaneously borrowing money at 4% while lending money to somebody else at a rate equal to the yield of the bonds in your portfolio. (For a Vanguard Total Bond Market holding, that would be about 1.5% right now.)
That would certainly suggest that it would be a good idea to liquidate some of your bond holdings in order to pay off the loan. But there are a few counterpoints that should be considered first.
Comparing (After-Tax) Apples to (After-Tax) Apples
The line of credit’s after-tax interest rate is likely lower than 4% when you consider the value of any deduction you’re currently getting for the interest. In contrast, if your investments are completely tax-sheltered (i.e., not in taxable accounts), then there would be no need to reduce the interest rate on your bonds in a similar fashion for comparative purposes. In other words, the spread between the two interest rates may not be as high as it appears at first glance.
Paying to Maintain Liquidity
In some cases, it makes sense to simultaneously borrow money at a higher rate than you’re earning on your lowest-earning holdings because doing so allows for greater liquidity, which offers a degree of protection against unexpected large expenses.
In this case, however, that’s unlikely to be a concern given that:
- The line of credit would still be there, available for a cash crunch, even if you paid it down, and
- A mutual fund portfolio well into the 6-figure range provides plenty of liquidity as well.
Additional Tax Considerations
Another thing to consider is the tax consequences that would result from liquidating holdings in order to pay off the line of credit. The answer to this depends on:
- Where the investments are held (e.g., Roth IRA vs. traditional IRA vs. taxable account),
- Your age and current tax bracket (if they’re held in a tax-deferred account), and
- Your cost basis in the investments (if they’re held in a taxable account).
For instance, if the investments you would be liquidating are all in tax-deferred accounts, even if you do decide you want to go ahead and pay off the loan, it might make sense to do it over 2-3 years rather than all at once, because such a large distribution in one year from a tax-deferred account would likely bump you into a higher tax bracket, and the additional taxes paid (relative to spreading it out over 2-3 years) might outweigh the interest saved.
What About Borrowing to Own Bonds and Stocks?
Finally, some people would argue that the appropriate comparison is not the interest rate on your bond holdings as compared to the rate on the line of credit, but rather the average return on your total portfolio as compared to the rate on the line of credit — with the reasoning being that having the bond holdings is what allows you to have the stock holdings without exceeding your emotional/mental tolerance for volatility.