Planning with Client Debt

By George Chamberlin

Debt takes many forms and is present in most client financial situations. This tells us that finding the best way to address that debt in our planning is an important part of our task. As a first step, it is useful to understand that debt is a tool and so there really is not good or bad debt, just debt that may have a variety of impacts, both positive and negative, on our clients.

If a client has debt, be sure to reflect that debt in the client’s assets and liabilities section as a component of net worth. Debt should not be ignored here since knowing there is debt allows us to plan around it and how it may affect the client in the present and in the future. Remember that existing debt may affect the client’s ability to obtain credit for other purposes or will cause the client to pay more in interest and other fees to obtain additional desired credit. Further, servicing existing debt tends to limit the client’s ability to save and invest from current income.

You will find that to some clients, taking on debt is simply a poisonous idea and those clients will do almost anything to avoid carrying any debt. That makes some of our planning easier but also deprives those clients of something – debt as a tool – which possibly could be helpful to them in certain situations. We will examine the most typical debt scenarios for clients and the relevant tax consequences. Then we will take a look at some modeling ideas for handling debt in a plan. Note that most financial planning software is NOT tax accounting software and so the particular tax consequences associated with your client’s debt may not be accurately reflected in the calculations for the plan.

Home Mortgage Debt

This is one of the most common types of debt and is typically necessary for clients to purchase their first home or in upgrading their homes. It will not be as common in the downsizing scenario though it may play a role there as well.

If the client takes out a mortgage, this action may free up other client funds for investment which may in turn provide a greater return on investment than the property mortgaged. If the funds were invested in the property, thus reducing or eliminating the borrowing, the possible growth of the funds as a separate, non-real estate investment would be foregone. The mortgage also allows the client to purchase more house than current liquid assets might permit and this leveraging may help the client meet another important goal.

Servicing the mortgage diverts some of the client’s current income, ranging from the payment of taxes to the interest paid on the loan, which is tax deductible. In particularly large mortgage cases, the income tax deduction can be substantial, though there are limits even here.

A second mortgage or home equity line of credit (HELOC) may provide extra cash for emergencies or to improve/maintain the home. Again, the client may leverage the investment in the property for other goals and will likely retain the income tax deductibility of the interest for this borrowing.

Similar considerations should apply where the client is borrowing in connection with a second or vacation home as mortgage interest on a second home is also income tax deductible. However, two homes is the limit and a client with a third property will have to make a choice as to which one will be deducted. A mortgage on a home a client does not plan to live in may also be subject to a higher interest rate such as that which may be applicable to investment property. 

Credit Card Debt

This is often called the worst type of debt one may hold since the interest rates tend to be high absent security such as with a home loan, the interest is not tax deductible, and spending with a card can be addictive for some. However, the thoughtful use of a credit card can allow a client to weather a period of unemployment or low cash flow or permit the client to tap the available credit to finance a small business startup or other similar activity.

For some of your clients, planning how to pay this credit card debt down – perhaps utilizing techniques such as balance transfer offers, introductory zero interest rates, paying off the smallest balance card first – is an important if not crucial step to improve a financial situation. Although much of this may be considered budgeting, it is still important to the client’s overall financial plan and a worthy subject of advice and discussion.

Auto Loans

The amount of these loans can be surprisingly substantial and, as is the case with other loans, servicing them can reduce the amount of income available for current savings and investment. However, transportation is always a necessity for clients (though it may not always require an auto or a loan) and must be factored into the client’s budgeting.

Typically, there is no income tax deduction available for interest paid on an auto loan. These loans may carry a low rate of interest – or not – and servicing them is again a regular part of the budget. However, a client has a fair amount of control over the timing and amount of these loans and they may not play an ongoing role in the financial plan since they are usually short in duration.

Education Loans

Most often we see this type of debt in the plans of recent graduates (or perhaps their parents as our clients and funders of that graduate’s education). It may be particularly impactful for graduates in some professions such as law and medicine where numerous expensive years of study can add up to fabulous amounts of debt. Although these loans may not carry an interest rate as high as that for credit cards, for example, the loan may be a significant burden on one’s budget and planning.

Fortunately for some lower and middle income persons, a portion of the loan interest may be deductible. Taxpayers with modified adjusted gross income below $80,000 ($160,000 for joint filers), may deduct up to $2,500 in interest on qualified higher education loans for the taxpayer, the taxpayer’s spouse or dependent.

Note that some education loans – such as government student loans – do not require payment while the student is still attending school more than half-time. There is generally a six month grace period for Stafford loans that runs from the time a student drops below the half-time attendance level. In addition, some student loans may allow a postponement or reduction in payment while the student is unemployed or the student’s income is low.

Client as Cosigner

You will find that some clients have cosigned a debt with a younger member of the family or someone else close to them. Cosigning a debt allows the primary borrower to obtain a loan they otherwise would not qualify for on their credit alone. This type of debt is important for two reasons, both of which your client may not fully understand.

First and most obvious is the risk that the primary borrower fails to service the loan with the result that the creditor comes back on the client who is also liable and is probably a much better source of payment. The second is the fact that the loan while outstanding may affect the client’s ability to obtain additional and favorable credit terms for future transactions the client wishes to engage in. A cosigned debt is, after all, a debt that potentially burdens the client’s ability to pay for more credit and will be considered in the loan process.

Reverse Mortgages

A reverse mortgage puts the homeowner in the position of receiving payments based on the homeowner’s equity in the property instead of the usual payment of principal and interest to a lender. Although the payments the homeowner receives are not taxable income to the homeowner, the payments received are in fact a loan against the value of the property and those payments, along with interest and other charges, add up over time. That loan will have to be repaid when the homeowner dies, sells the property or moves out of the home. At that time the interest will be deductible only where the total loan does not exceed $100,000.

This type of debt is not for everyone and their financial situation, longevity, value of the home and any mortgage already on the property will all play a role in determining whether to participate in a reverse mortgage. When a reverse mortgage is in place the obligation will greatly constrain the homeowner’s options with regard to the property. As is the case with a standard home mortgage, the homeowner remains responsible for the costs of insuring the premises, paying the property taxes and generally maintaining the premises in good condition.

Some Modeling Points

Quite apart from the various types of debt the client may have, we also need to address how we may treat a client’s debt within the client’s financial plan.  The starting point is, of course, to list that debt among the client’s liabilities and understand its effect on net worth.

In terms of cash flows in the plan, debt service usually is a part of a client’s pre-retirement budget and not broken out as a separate financial goal. Since we are relying on the client’s ongoing income to provide for these and other expenses, we do not draw down on client assets for the payments. The most common exception is where a client may require a lump sum to pay off a debt entirely and will take that from client investment assets. This will occur, for example, where the client decides to pay off an auto loan or second mortgage. When a client sells one house and purchases another, the timing of the transactions will dictate how we reflect it in the plan. A down payment typically comes from assets while proceeds often go towards settling an existing mortgage debt with the remainder flowing into the plan.

Retirement poses a somewhat different situation for our modeling of debt and debt service. Just as we did prior to retirement, the servicing of smaller debts such as credit card debt, often is rolled into the general retirement spending goal. This makes sense from a budgeting standpoint and for how many clients view that debt and their monthly expenses. However, in the case of larger debts and/or those that are not expected to run to the end of the planning period, we may better use a different approach. Here we may break out the payments as separate goals each with its own specified duration and often, as in the case of a traditional mortgage, with payments that do not change or grow over time unlike most typical spending goals. Breaking these goals out ensures we handle them correctly and that the baseline retirement spending is more accurate.

Finally, there may be a modeling opportunity with respect to income tax impact of debt on the plan. For example, where a client has a large interest deduction for a mortgage, it will likely have some impact on the client’s income tax obligation. This can change brackets for some clients and that will impact how the overall plan results are calculated. You may be surprised at the effect on the plan result of properly modeling such debt.

Other Loans and Issues

Our focus here has been on loans a client is likely to sign in the context of his or her personal financial plan. Loans obtained by another entity, such as a business or trust, are beyond the scope of this discussion even when owned by a client. Similarly, the issues presented by forgivable loans, such as those made by an employer to an employee, are not covered here.

Also outside the scope of our discussion is the question of foreclosure, bankruptcy and forgiveness of indebtedness income. These are all issues relevant to the handling of debt in adverse circumstances and the special rules and requirements make this better addressed elsewhere.


George Chamberlin has been working in the legal and financial industry for over thirty years, including working at Wealthcare Capital Management from 2002-2009. George practiced law for several years before focusing on writing, planning and software development in the estate planning and financial planning areas. During his time at Wealthcare, George wrote weekly e-mails for advisors and their clients, engaged in basic and advanced financial planning and estate planning as well as working on a variety of other Wealthcare projects. Since 2009, George has worked as a registered investment adviser representative in his own firm, meeting and planning with clients, and more recently as a consultant to financial advisors, including Wealthcare advisors, on a variety of matters including advanced financial and estate planning.

 George Chamberlin & Mentor RIA Consulting © 2015