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Learn to differentiate constructive and nonconstructive debt


When used strategically, debt can enhance your wealth and your life in meaningful ways.

It’s no secret debt has an unsavory reputation. The word alone can conjure images of mounting credit card bills and relentless collection calls. But not all debt is bad debt. In fact, if you approach it strategically, debt can be as useful as any other financial tool.

It can be helpful to think of debt in two categories: constructive and nonconstructive.

Nonconstructive, or destructive, debt can derail your goals and diminish your income by:

  • Hindering your ability to grow your assets
  • Bearing interest costs that exceed market or investment returns
  • Limiting your potential tax advantages
  • Preventing you from easily repaying what you owe through cash flows or predictable revenue streams

Alternatively, constructive debt refers to borrowing money that can ultimately enhance your wealth or your life in a meaningful way. A few examples include securities based lending1, margin, home equity lending and mortgages2. This type of debt, which can be easily repaid through cash flows and/or predictable revenue streams, can be used to:

  • Purchase appreciating assets. A classic example is using a mortgage to purchase a home. But this can also apply to purchasing land, starting a business or even investing in your education.
  • Prudently manage taxes3. Having access to liquidity through lines of credit can allow you to meet unexpected expenses without needing to sell your securities. This can also help you mitigate capital gains tax implications.
  • Add flexibility to your financial plan. A reliable credit line can help you make the most of an unexpected business venture, a home renovation or another opportunity you don’t want to pass up – all without disrupting your financial plan.

Timing the market vs. time in the market 

Taking money out of investment accounts to avoid taking on constructive debt could derail your long-term goals. Missing out on even a handful of the market’s strongest days could mean missing out on significant gains. And the data proves it: Based on S&P 500 index returns from 1990 to 2019, remaining fully invested produced a return of 7.4%, while missing just the 10 best days produced a return of only 3.3%.

In addition, a low interest rate environment, such as we are in now, can make constructive debt even more strategic. It’s a matter of weighing the cost of borrowing against the potential cost of missing out on market returns.

Consider this hypothetical scenario4: Luis and Anne each have $1 million in investable assets. They each buy a home for $500,000. Luis decides to liquidate his investments and purchase the home with cash. Anne opts for a $200,000 down payment using a securities based line of credit with an interest rate of 5% along with a $300,000 mortgage with an initial interest rate of 5%.

Luis ends up with $500,000 in investable assets; Anne still has $1,000,000 invested but is paying 5% interest on $500,000 in debt. Assuming the two investors earn a similar rate of return on their invested assets, as long as that rate of return is higher than the 5% Anne pays on her debt, she should come out ahead.

This is just one way constructive debt can help investors stay invested and continue growing their wealth.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Past performance may not be indicative of future results.

Pay down debt or build up an emergency fund?

If you find yourself with extra cash among your everyday expenses, it’s important to consider your options. Funding your retirement accounts is always a good idea, but so is tackling nonconstructive debt.

Many experts suggest using extra cash to contribute the maximum allowed in your retirement accounts. You’ll definitely want to contribute the maximum your employer will match for your 401(k) – and remember that employer matches do not count toward your 401(k) contribution limit.

After that, you’ll want to use any leftover funds to pay off nonconstructive debt, particularly in high-interest accounts. Once the debt is paid, you can divert your attention to building up your rainy day fund, establishing a safety net for unexpected financial events such as a job loss or medical need.

Whether you’re seeking to harness the benefits of constructive debt or focus on building an emergency fund, your advisor can work with you to assess your investment options and help you confidently step toward the tomorrow you envision.

1A Securities Based Line of Credit (SBLC) may not be suitable for all clients. The proceeds from an SBLC cannot be (a) used to purchase or carry securities; (b) deposited into a Raymond James investment or trust account; (c) used to purchase any product issued or brokered through an affiliate of Raymond James, including insurance; or (d) otherwise used for the benefit of, or transferred to, an affiliate of Raymond James. Raymond James Bank does not accept RJF stock or any securities issued by affiliates of Raymond James Financial as pledged securities towards an SBLC. Borrowing on securities based lending products and using securities as collateral may involve a high degree of risk including unintended tax consequences and the possible need to sell your holdings, which may lead to a significant impact on long-term investment goals. Market conditions can magnify any potential for loss. If the market turns against the client, he or she may be required to quickly deposit additional securities and/or cash in the account(s) or pay down the loan to avoid liquidation. The securities in the Pledged Account(s) may be sold to meet the Collateral Call, and the firm can sell the client’s securities without contacting them. A client is not entitled to choose which securities or other assets in his or her account are liquidated or sold to meet a Collateral Call. The firm can increase its maintenance requirements at any time and is not required to provide a client advance written notice. A client is not entitled to an extension of time on a Collateral Call. Increased interest rates could also affect LIBOR rates that apply to your SBLC causing the cost of the credit line to increase significantly. The interest rates charged are determined by the market value of pledged assets and the net value of the client’s non-pledged Capital Access account. Securities Based Line of Credit provided by Raymond James Bank. Raymond James & Associates, Inc. and Raymond James Financial Services, Inc. are affiliated with Raymond James Bank, a Florida-chartered bank.

2Raymond James Financial Services and your Raymond James financial advisors do not solicit or offer residential mortgage products and are unable to accept any residential mortgage loan applications or to offer or negotiate terms of any such loan. You will be referred to a qualified Raymond James Bank employee for your residential mortgage lending needs.

3Raymond James does not offer tax advice. Please consult your tax advisor for questions regarding your tax situation

4This case study is for illustrative purposes only. Individual cases will vary. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Prior to making any investment decision, you should consult with your financial advisor about your individual situation.

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