Leverage. It's a wonderful thing. Real estate investors and homeowners use it all the time to magnify their returns. However, leverage works both ways. It increases returns by increasing risk. What is the risk? The risk that you cannot service the debt.
Regular readers know I'm not a huge fan of debt. I'm not quite as rabid as the Dave Ramsey types (although even he makes an allowance for 15% of income toward retirement and saving for college before paying off a mortgage), but I certainly lean in that direction. I quoted Mormon Leader J. Reuben Clark (1938) in my book:
Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours; it never has short crops nor droughts; it never pays taxes; it buys no food; it wears no clothes; it is unhoused and without home and so has no repairs, no replacements, no shingling, plumbing, painting, or whitewashing; it has neither wife, children, father, mother, nor kinfolk to watch over and care for; it has no expense of living; it has neither weddings nor births nor deaths; it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands, or orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you.
Deleveraging Before Retirement
I've been surprised to learn that 80.2% of “near-retirees” carry household debt, including $103K in mortgage debt and $18K in consumer debt. That includes all those middle-class schmucks, right? Nope. For those in the top 1/3 of income, it's $200K in mortgage debt. We're doing the same thing, just with larger numbers. 30% of households over 70 have mortgage debt. That seems like a terrible idea to me. I think it's idiotic to go into retirement with any consumer debt at all or any mortgage debt on your primary residence. In fact, I don't even think it's a great idea to retire owing any significant amount on your investment properties. Here's why:
#1 Security
Retirement finances aren't just about being secure, they're about feeling secure, and people feel more secure when they own the house they live in. No one can raise the rent. No one can take it away from you (assuming you pay the taxes, and even that takes forever before the government steps in throughout most localities.)
#2 Tying Up Income
Deleveraging While Young
Besides retirees, there is another group that can really benefit from “deleveraging their life” by paying down debt. These are the folks that are relatively young and owe either massive amounts of debt (think physician-style student loans) or high-interest debt (think about the poor schmucks on the borrowing side of 23% peer to peer loans or who carry credit card debt month to month.)
These folks are taking on a massive amount of financial risk. I am now routinely hearing from physician couples who owe upwards of $900K. Many current medical and dental students expect to owe more than $400K upon completion of training. $900K at 8% paid off over 10 years requires payments of more than $11K, after-tax, per month. Assuming a 33% combined tax bracket, we're talking about $200K of annual gross income just going to service the student loan debt. Let's hope they're not both pediatricians who have never heard of PSLF! If just one doc becomes disabled or wants to stay home with the kids or whatever, they're going to be living a subsistence lifestyle until that debt is paid off.
The Author deleveraging his life by getting closer to the ground while rappelling from Eichhorn's Pinnacle, Tuolumne Meadows
Even small amounts of high-interest debt can have similar effects. A $50,000 credit card debt at 29.9% requires the payment of $15,000 in interest a year! After tax, that's more than the monthly income of the average physician.
If you're in either of these situations, you need to deleverage — lest some tiny hiccup come into your life and cause you to go bankrupt or get foreclosed on. (Nobody talks about it in the doctor's lounge, but both of those happen to physicians all the time. Hint-look around for the guy who's running a full clinic, playing hospitalist 4 nights a week, and looks like he's about to collapse. That's the guy.)
Sometimes it's not just the student loans. It's $200K of student loans (not terrible by itself, especially once refinanced), plus the $600K mortgage, plus the $80K boat loan, plus the $50K car loan, plus the $250K mortgage on the little cabin. In the end, it's all the same. Interest must be paid.
Deleveraging at Market Highs
There is another time in life when deleveraging may be a good idea besides before retirement and shortly out of training. That's when asset prices are relatively high by historical valuations. Although we've technically had two very brief bear markets in the US stock market since 2009, nobody actually remembers them. Ignoring them, stocks have been going up for over a decade now at an average rate well above expected returns. Similarly, real estate values have climbed dramatically in most areas of the country since 2010. Bond yields continue to be near all-time lows. Rather than taking on ever more equity risk (small value, emerging markets, etc), leveraging up your real estate portfolio, or reaching for yield in the bond market, perhaps now is a great time to take the low, but guaranteed, return available to anyone carrying debt.
Mathematically, you can always make an argument that it's smarter to carry debt. I know it as well as anyone. I used to have a 2.75% 15 year fixed mortgage (perhaps 1.55% after-tax). We carried it for a year or two longer than we needed to because any reasonable student of financial history will concede that it's unlikely that our long-term portfolio returns will be less than 1.55%. But 1.55% would have beat the socks off my portfolio return for 2008! We eventually paid it off anyway back in 2017.
The other issue with low-interest debt is that we start forgetting it is there. We look at the math…of course, I can beat 2%, or 5%, or whatever with my investing. But we don't, because we don't invest it at all. Instead, we spend it. And a 2% return always beats the negative return you get from a BMW, a boat, or a new wardrobe. We gradually become accustomed to that 2% debt such that we carry it for a long, long time. Meanwhile, we work 2 or 3 extra calls or shifts a month to pay for that.
My Life and Your Life
When this post was originally published in 2014, I said this:
Personally, I've got a debt at 5.35% on an investment property. After-tax, that's probably at least 3.3%. Meanwhile, I've got money invested in the G Fund paying 2.375% and a TIPS Fund with a negative real yield (probably a nominal yield of 1.82% or so). Paying down my debt is like buying a bond yielding a guaranteed 3.3% that won't be impacted by rising rates! Not spectacular, but certainly attractive compared to current bond yields and possibly compared to stock yields in the event of a market downturn. Timing the market? Perhaps. Hedging my bets without having to even touch my investments? Seems a more appropriate description.
If I was considering paying down debt more rapidly than required at that time, and I'm one of the least leveraged physicians I know, perhaps you ought to consider it as well.
Now I'm not saying you have to live like a resident until your home is paid off. Moderation in all things. But it will ALWAYS seem like there is something better to do with your money than pay off debt, whether it is investing or spending. Once you realize that, you may find a little more motivation to use your extra cash to deleverage your life before retirement, when you're buried by debt, and at market highs.
What do you think? How do you decide when to pay extra on your debts? How much are you willing to bet your portfolio will outperform paying off your mortgage (or your students loan) over the next 1, 2, or 5 years? Comment below!
Great article. I know much has been written (and commented upon) this subject on-line re: deleveraging and debt freedom. (I spent a lot of time researching the topic before I did it.) I am not a debt freedom fanatic. I do understand the trade-offs between paying down debt vs investing, although many doctors spend rather than invest!
From the perspective of having deleveraged at a relatively young age (45), I think I have perspective on what it felt like being in massive debt (>$1 million – 2 physician couple’s student debt, mortgage) and also being debt free (including mortgage) with a very healthy retirement fund.
I too agree with moderation in all things, the one unexpected benefit I noticed was a generally improved disposition towards life. The hassles of practicing medicine seem less. The anxiety about the future also seems less daunting. I am more concerned about picking my marks in life (what do I want to do professionally and personally) rather than what I need to do in order to get ahead (or not fall behind.)
The ROI of knowing that if professionally everything hit the fan, my family and I would still be OK gives me a huge sense of satisfaction and peace. This is a personal decision for everyone based on their risk tolerance. I agree that carrying debt into retirement is pretty scary (and stressful).
The first rule of thumb is not to take on a huge mortgage in the first place. Save up to avoid PMI which is a waste of money.
All of your arguments are behavioral. Most studies show that investing rather than mortgage paydown nets you more money in the end. I sleep better at night knowing a plaintiff’s attorney won’t want my Home if it is so encumbered.
I pay for life insurance every year to pay off my mortgage if I die.
All these arguments ignore the optionality of a mortgage. If I have the discipline to invest the pay-down amount into a taxable account, I can pay off the mortgage at a time of my choosing and at cap gains rates, which may be zero once I retire.
I love this blog but I find this argument weak. As you acknowledge, at low interest rates, one will very likely come out ahead by investing rather than paying down mortgage debt. That doesn’t magically change once one retires.
As far as feeling more secure, if you feel more secure paying off your mortgage, go ahead, but a few 100K of remaining principal at a low fixed term wouldn’t bother me at all.
There are a couple of other points that argue in favor of investing not paying off the mortgage as well as well. One is that for most people who stay in a house the percentage of income devoted to the mortgage declines over time due to inflation. What seems like a big mortgage payment at 40, will likely be much less in real terms 20 years later. Second, money invested in a taxable account is 100% liquid, home equity is not. I suspect it gets significantly harder to take out a home equity loan once you retire and can’t demonstrate income.
I don’t think paying off low interest debt is wrong, but when I look at the numbers and see I’m much more likely to come out ahead by investing I’ll go with the math
Dr. X
No, the likelihood of coming out ahead might not change (actually it does a bit since you have less time in life to make up for poor returns) but your ability to service the debt without affecting your lifestyle sure does.
WCI,
First off, I really appreciate this site and agree on many topics. And,even when I disagree, I respect what you share.
That being said, I really think you tried to simplify the scope of this argument too much. Reading through the discussions here, you have made the arguments that 1. many people are too leveraged (ie. those who carry 900k 1st mortgage, a 500k 2nd, a boat, a car, etc.) and 2. any debt should be paid off regardless of its interest rate and ratio of debt-to-income/savings.
I don’t think the second argument holds water unless you begin to make broad and (often) inaccurate assumptions about your audience.
It is too convenient to argue that people will not do with the extra money what they should (i.e. invest it rather than spend it). If you are going to make that assumption about your audience, then none of your advise is going to help them anyway.
A person with a reasonable debt-to-income/savings ratio with a low interest rate is mathematically way better off investing rather than paying down debt. Furthermore, the liquidity of the extra money is much more valuable in the event where a life-changing circumstance arises (which is part of the argument you have made to be debt-free).
Example: person with 600k in house debt at 3.5% with mortgage payment (including taxes, etc) of about $3500/month (This is a guesstimate). For four years they pay an extra $1000/month to pay off early, then unexpectedly lose their job.
Their payment is still $3500. Unfortunately, instead of having $51000 (assuming a conservative 5% return) in an investment they can tap for 14 months while job searching, they have $0 and 3800/month to come up with. Using your own assumption that they spent what they didn’t put into their mortgage (I realize I’m being a little hypocritical but I’m just highlighting the unfairness of that assumption here), they also don’t have an additional $3500/month in cash to cover this.
The bank is not going to give them leniency just because they were good about making extra payments for 4 years. That payment is due every month, even if they have no income. But with losing their job, the bank is not going to feel great about refinancing that debt, nor is the person in a position where paying extra money to refinance is really helpful.
Basically that person puts themselves at risk of having to sell their house at whatever the market will bear in the event of unanticipated unemployment to capture the money they put into it when it wasn’t necessary.
This is even worse for a person that pays off low-interest student loan debt early, because none of that will go toward equity in anything. It’s just gone.
I personally think being debt-free for the sake of being debt free is overrated. I believe there is a such thing as “good debt” (i.e. low interest rate, low ratio of debt-to-income/savings). I also feel that retirement is not a guarantee for everyone and preparing for it must be balanced with living a happy life in the moment.
If the person in the example decides to retire 20 years into their 30-year mortgage and does not want to carry that debt into retirement, they will have $397K (assuming that 5% return) to pay off the remaining 247k of their debt, rather than 89K saved from 19 months of mortgage-free life had they paid off early (3500/month + 1000/month extra x 19 months– you would, of course, have to subtract property taxes from that).
Though they may simply decide they want to continue the mortgage payment and keep the liquidity of the nearly $400k they have, or sell their house and buy a condo in the Caribbean…who knows?
The point I am trying to make is that not all debt is “bad” debt, just as not all “low interest” debt is “not bad” debt (i.e. when your debt-to-income/savings is too high). In making the argument that everybody should be completely debt free, you make too many assumptions about people that should not and cannot be generalized.
Thanks again for all you provide in guidance and insight on these topics!
pc
All good points and only one minor criticism. The issue about choosing to invest instead of pay down debt to preserve liquidity may be an issue if you lose your job at the same time the value of your investments tank.
I rarely see someone who was debt-free go back into debt. If you’ve never been debt-free, it might be worth becoming so to decide whether you like it or not. You can always remortgage the house etc. I worry lots of people justify carrying tons of debt with a mathematical argument, but don’t actually do the behavioral things that allow them to take advantage of the math.
Fair enough. But if we assume a 10% market LOSS for each of those 4 years in the example, the investor still has around 37K in the bank to keep paying the mortgage for 10 months while job searching (~29k assuming no gain for 3 years and a sudden 40% drop in the 4th). Furthermore, if the MARKET tanks so, likely, will their home value, making an emergency sale with no savings cushion all the more costly, even with an extra 48k paid down.
For those that DO choose to pay off low interest debt, I would also make the suggestion that that they should pay a house down first and a low interest student loan second. The reason being that student loan creditors are less likely to take your house like the bank will should hard times come along, and the extra money you are paying on a home loan is actually going into a quazi-savings account (home equity) assuming you are not underwater with the loan, rather than disappearing into some bank’s coffer.
Regardless of that, I agree that many people have too much debt and even if it is low interest debt, too much of it is a bad thing. I also think the argument for choosing times during which to pay off debt rather than investing is an interesting one and one that I have contemplated. I just don’t really know enough about what the market will do to make the decision about when that time would be right.
I find it interesting that you seem to think there are no negative consequences of carrying student loan debt. You can discharge home related debt in bankruptcy in many states, but not student loan debt. You’re stuck with it until death if you don’t pay it off.
I did not say to stop paying student loans(or mortgages). Only that if you have both and are going to make extra payments into one, the home loan seems the better first choice, since it reduces debt while at the same time maintaining wealth.
Is there a strong case against that logic?
I had not considered bankruptcy previously. I will put more thought into that. But on first instinct it would seem that most physician’s greatest risk of bankruptcy comes from professional liability. In that case, perhaps money spent on some sort of umbrella insurance policy might be better before paying down student loans OR a mortgage if that is the concern?
I’m not an expert. That’s why I’m here. I welcome all holes punched into my raft while I’m still near the shore!
If you have a $500k 3% 15-year mortgage and a $200k 5.5% 10-year student loan, which one should be prepaid first? The answer is a little counter-intuitive. If you prepay both loans with extra $3k a month, your prepayment savings will be as follows:
1) Mortgage: $65k
2) Student loans: $42k.
So before you actually decide to prepay one vs. the other, make sure to run the numbers. You don’t need to guess – everything can be calculated very accurately.
Here’s another way to think about prepaying. What would be the alternative to prepaying the mortgage? If you put the extra $3k a month over 4 years (this is how long it would take for you to pay out a 15-year mortgage), or $144k over 4 years, what return would you need to get $65k in profit? You lose about $14k to interest deduction vs. the prepaid loan, so the total you’ll need to get is $51k. If I did my math right, the actual return on the $3k a month prepayment is around 12%. The actual return is more like 9% (if we consider the opportunity cost of investing $3k at 3% into a municipal bond fund for example).
You didn’t do your math right if you calculate that making extra payments on a 3% mortgage gets you a 12% return. You get 3% (actually less due to the interest deduction.) I also disagree with your choice of which loan to prepay first. Paying the highest rate one will get you the highest return (and savings). That’s why it’s called the highest rate. If you’re not getting that when you “run the numbers”, you’re running them wrong. Unless you’re expecting loan forgiveness, paying off a 3% deductible loan that can be forgiven in bankruptcy instead of a 5.5% non-deductible loan that cannot seems foolish.
Here’s a great calculator, BTW: http://www.mtgprofessor.com/calculators/Calculator2a.html
If you have a 5.5%, 200K, 10 year loan, the regular payments are $2170.53 for 120 payments. You’ll have paid a total of $60,462.93 in interest. If you pay an extra $3000 per month, you’ll make 42 payments of $5170.53, plus one payment of $3493.51. You’ll have paid a total of $20,655.77 in interest, saving a total of $39,807.16 over about 3.5 years. The rate of return earned by your extra payments is precisely 5.5%.
If you have a 3%, $500K, 15 year loan, the regular payments are $3452.91 for 180 payments. You’ll have paid a total of $121,523.44 in interest. If you pay an extra $3000 per month, you’ll make 86 payments of $6452.91 and one payment of $1504.02. You’ll have paid a total of $56,454.28 in interest, saving a total of $65069.16 over about 7 1/4 years. The rate of return earned by your extra payments is precisely 3%. Did you save more interest by making payments on the mortgage? Sure. But you also made the extra $3000 payments for twice as long!
What if you only made the extra payments for the 43 months you would have paid toward the student loans? What then? You then pay the loan off in 129 months, paying $70,977.88 in interest (so you’d save $50,545 in interest versus paying it off in 180 months.) But it would take you LONGER to get those savings versus paying it toward the student loan. The fact remains that the rate of return on that money is still just 3%. Under no circumstances does it become 12%. You can only get that answer by ignoring the time value of money.
If you want to pay your loans off as fast as possible, paying as little interest as possible, and have an extra $3000 per month to throw at them, the correct sequence is to pay the minimum on the mortgage, and throw $3000 at the student loan each month. After 43 months, the student loan is paid off, and you can redirect the $3000 plus the $2170.53 student loan payment at the mortgage. By doing this, you can have them both paid off in less than 8 years, while saving $47K in interest on the mortgage and $40K in interest on the student loans.
Litovsky’s Reply via email:
Here is my reply to your post about my calculation:
I made a mistake for sure – doing too many things at once. Assuming no
phaseout, the tax savings are much larger (~25k), so the mortgage
prepayment savings are only $40k or so after the deduction, so they are
tied. Thus it does make sense in this case to take care of the loan
quickly (because the return on the loan prepayment is higher) and then
proceed to take care of the mortgage after the loan is paid off. Thank
you for checking the math!
As far as return, I assumed mortgage is paid out over 4 years (I somehow
used a lower amount, probably $200k in my calculator, thus my
mistakes). It is actually pre-paid over 7.9 years (full payment over
about 6). So the return is actually under 3%. Next time I promise to
do a spreadsheet.
And this follow-up from Litovsky via email:
Actually, if we assume that the mortgage is paid out over 6 years (full payments), here’s how the calculation goes to figure the ‘return’ on prepayment:
$36k over 6 years = $216k
At the end, we have a total return of $40k (so we’ve saved $40k).
What should be the interest at which $36k a year is invested at 6 years to get an excess return of $40k ($256k final amount)?
I’m getting around 5%.
My reply:
Your calculation is still missing something. The rate of return for making extra payments on debt is precisely the interest rate of the debt (ignoring any tax consequences). If your calculation doesn’t show that, the calculation is wrong.
Excellent analysts, as always.
I paid off my home in 11 years, for many of the reasons you discuss here. A wise senior partner once said, “You can withstand a lot of financial hardship if you own your own home.”
Many of my partners and colleagues have homes too large and too leveraged to even consider paying off. And I really shook my head when the new colleague, fresh out of training, bought a lot in a prestigious old neighborhood, torn down the existing home, and built a new home. Let’s hope for him rad onc reimbursements rise faster than the pace of college tuition. Oh, yeah, they are falling like a lead balloon and current projections have him working until age 127 years old to pay off the fancy house!
Lots of truth here; this is the reason I come to this website. Thanks for keeping me grounded and focused.
You got dyslexic on quoting the “Mormon Leader” though: his name is J. Reuben Clark (Jr).
Sure did, thanks!
Great post and some good food for thought which agrees with my bias. We currently have only a mortgage which is at 3.375% interest. We typically have saved 30% of our income for retirement. Because of the great run in the market in the last several years, last year we cut that back to 15% knowing that would allow us to pay off the mortgage within two years. I figured that would allow us to continue to participate in the market since we can’t predict it but given the great bull run it might be a good time to cut back for a couple of years to be completely debt free. Next year we can resume the 30% savings for retirement. We have been fortunate to be able amass a several million dollar portfolio through savings and sound investing. We just welcomed another baby in our family so I plan to work for quite awhile so my kids know that you have to work for a living. I love my job as a physician but someday I may not love it as much so we are doing this to allow us to freedom to dictate our own lives. While we are saving a good chunk we are still blessed to live a more comfortable life than most. I look forward to the peace of mind next year when we are completely debt free. Thanks for all you do to educate the masses on good financial principles.
“Paying down my debt is like buying a bond yielding a guaranteed 3.3% that won’t be impacted by rising rates!”
I think you are underestimating the value of paying down your debt by comparing after-tax cost of debt vs. pre-tax investment returns. You would have to pay taxes on any bond interest (unless you bought a muni bond, in which case you would only pay state taxes. If you can get a AAA muni bond paying 3.3% then take it, because none are paying those rates these days). To get a realistic comparison you’d have to buy a corporate bond paying 5.35% to get the same rate.
I ignored the tax adjustment on the bonds because the ones I was thinking about were in a tax-protected account. But you’re right that everything ought to be compared on a post-tax basis.
For the last year, every extra dollar that I pay towards the mortgage, I put a dollar in a taxable stock fund. So far, paying off the mortgage has been the better outcome. Eventually, I’ll use that stock fund to pay off the remaining mortgage!
Sounds like a great way to split the difference.
Wealth can be amassed with or without leverage:
1. 10 million assets – 8 million liabilities = 2 million net
2. 2.5 million assets – 0.5 million liabilities = 2 million net
3. 2 million assets – 0 liability = 2 million net.
Consider which of the paths before you feels most comfortable to you given your risk tolerance. In considering the math of the choices, do not forget the intangibles of the choices. Choose with intention and choose wisely.
This comparison is silly without actual numbers on what the interest on the debt is and the risk/returns on the investments are. Depending on the situation either extreme can be overwhelmingly the correct choice (far outweighing any “intangibles”).
Perhaps. The point is to know all your personal details and choose where you are comfortable with risk reward analysis. Many young docs don’t seem to consider some very simplistic (silly) concepts in making these choices although they are probably not reading this blog:) Do not underestimate intangibles although their value is different to each individual they matter and can be quantified. Twenty five years ago intangibles of debt freedom and peace of mind were honestly not even in our thought process. Now they top our list of considerations.
That’s not entirely true as for many, asset and liability values can fluctuate quite a bit. The value of a small business or real estate can drastically change in a short time period.
So, each person needs to decide for themselves how much fluctuation they are able or willing to tolerate. Personal situations and age can change your ability or desire to tolerate debt. Using debt to amass wealth seems to be very comfortable for many. For us, keeping track of the overall net of all our finances over time, in addition to the individual details of debt repayment vs. investing in the shorter term, helps clarify the decision for us. (Kind of a forest for the trees view.) We don’t all have to think about this stuff the same way.
It is not as much being comfortable with a particular risk tolerance, but rather having an understanding of what the fluctuations actually are (and realizing that risk tolerance is often based on the wrong assumptions). If they are bunch of small moves that rarely go down more than a couple of standard deviations, then anybody can tolerate them. If the fluctuations can be huge with a prolonged period of underperformance, then we are less likely to tolerate them (and the harm to one’s finances can be great). I doubt that most people can tell the difference between the two. Without getting into the math, I suggest taking a look at this for some ‘calibration’ – the reality can be quite nasty, so do mind the risk of being leveraged – it is worse than most people realize (no wonder 2:1 S&P ETFs are highly regulated):
http://wpfau.blogspot.com/2014/01/greatest-hits.html
Very interesting. Thanks! Shows why for our personal situation we are less tolerant of debt. It would be nice to solely think about paying off debt in mathematical terms. Life has not afforded us that luxury. In Chapter 4 of DeMuth’s The Affluent Investor he discusses personal risk profile which for us helps us make decisions like paying off low interest debt v. investing.
In general, debt is viewed very negatively in the Bible, so this might be where a lot of people draw their preferences. Basically, someone who is in debt is a slave of the debt holder, which is true. That said, if someone does have a lot of extra money, it can be used as leverage (for example, buying very large term life insurance policies can be considered leverage), or investing into real estate or venture capital.
Someone with not as much money (but with a lot of leverage relative to their wealth) should be a lot more careful, especially while they are accumulating their nest egg. Sometimes this can’t be avoided (for example by those who own their businesses and have large business loans – as many dentists do). In that case they might want to be a bit more conservative with the rest of their portfolios (at least for as long as the debt is outstanding).
So WCI, if one has an 80/20 portfolio and 500k in it would you take to 100k in bonds and pay down a mortgage or other debt, even if it’s at 3%? I ask because I go back and forth with doing just that. Instead of just making the required payments on the home or school, which should be paid off in less than 5 years, I could take the amount of money I’m putting into my taxable accounts and put 80% into my index funds and the other 20% into the extra debt payments instead.
The only reason I haven’d done it yet is because rates are so low it seemed more of an emotional choice than a mathematical one.
Sorry about the spelling errors, just read the post again… should have read it before posting.
Aside from the fact that he sold me overpriced actively managed funds and whole life insurance, this issue is a big reason I broke up with my “financial guy” (a northwestern mutual insurance salesman). I wanted to put all my leftover money after maxing out my tax deferred retirement accounts towards my student loans, and he insisted that increasing assets was more important than deleveraging. Thanks to what I’ve learned from this site, I was confident in disagreeing with him.
Similar issue here, We are now actively working on paying down debt, which will be manageable. Our “advisor” wanted us to keep pumping the money into our accounts, which happened to be increasing the fee that he earned. Didn’t earn any money on us paying down the debt.
Unfortunately, that’s the biggest conflict of interest of advisers who are compensated with asset-based fees.
http://litovskymanagement.com/2012/08/no-aum-fees
This is one of the biggest reasons why I switched to a flat fee model. I find that most physicians and dentists start out with a huge debt load, and there can be a lot of money saved by optimizing repayment, consolidating debt and doing repayment vs. investing analysis.
I struggle with this idea. I have very low interest student loans (under 2%) and a mortgage with an after-tax rate of 2%. I already max out tax-deferred space and backdoor Roth IRAs. I have a taxable account that I put a considerable amount in monthly. But I have extra money that I’m not sure where to put (debt vs invest). For now I do both, some to taxable and some towards debt. Given my low interest rates I’m sure I’d come out ahead with investments, but I also want to decrease my debt burden to a reasonable amount in case/when my reimbursement really takes a dump.
If your rates on debt are that low, then, as you point out, the obvious choice is to pay a minimum on your debt and invest (even in a taxable acct if that’s all you’ve got available).
Yeah, your income could go down. But if you’ve got as much extra available for savings as it seems, then it seems like you could withstand a quite a bit of income reduction before you would be put in a position to liquidate investments in order to pay for debt. Furthermore, if that time is far enough down the road (and odds are it may never come), you will still come out ahead by liquidating investments and paying down debt (versus just paying down low interest debt now).
For some dentists/physicians the mortgage deduction is phased out, so it makes more sense for them to prepay their loans. Depending on the tax bracket, if you want an alternative investment, one of my favorites is individual municipal bonds. However, given the uncertainties in the market, paying out your debt is a guaranteed way of making money, but you probably shouldn’t put everything int repaying sub 2% debt. Look at it as diversification of sorts – investing in Roth, tax-deferred, after-tax and debt.
Whenever you run the numbers in the long term it seems to me it almost always makes sense to use you extra money for equity investments which an average return of just under 7% after inflation over the last 150 years. With that figure in mind when you can leverage assets for less then 5% interest you should almost always do it, thus obtaining a 2% gain over the long term.
The problem is if you used that logic from 1966-1981 your equities basically broke even and so anything you leveraged was just straight up debt with no added gain. So while I’m a fan of leveraging assets I believe you have to take into context where we are in long term market trends in order to get the best return on investments.
This is totally a biased response, but looking at long-term Elliot Wave theory (which can be debated on another post) it appears we are in one of those times it may not be advisable to leverage your debt and try to make up the difference with interest gains. If I had less then 10 years to retire, which fortunately I do not. I would try and pay down all of my debt before investing excess money into equities and even then I would put myself into an even more conservative allocation heavy in money markets.
But ultimately it’s a personal decision in which each individual has to weight the pros and cons for their unique situation. However for me it’s fairly simple would I rather give up a possible 2-3% annual gain over the next 8-10 years and possibly need to work an extra year or 2, or risk losing >50% in the ensuing bear market that will likely be worse then that of 2008-09 and feel I need to work until I physically can’t?
The point of this post, which I don’t think I got across very well, was that it isn’t simply a comparison of expected earnings to cost of the debt, even when adjusted for risk. It was that the massive amount of leverage that many doctors have is simply too much leverage. Add in a $900K mortgage, a $500K mortgage on a cabin, $400K in student loans, an $80K boat, and a $300K practice loan and it’s just too much, even if it is all at 2%. The risk of something happening to your income where you couldn’t service the debt is too much.
I don’t think I buy into Elliot Wave theory. Too few data points IMHO.
Investing vs. prepaying is a really interesting problem. I’ve done some back of the envelope calculations in the following post:
http://litovskymanagement.com/2014/02/debt-repayment-basics
and came to the conclusion that the math has to make sense before we make sweeping assumptions about future returns. It makes a lot of sense to repay high interest debt quicker. Stock market should not be taken for granted. If anything, doing both will provide diversification. Stock market returns are statistical in nature, and they can be anywhere, from very high to very low (and we don’t really know where they will end up in the future), while high interest rate debt is very predictable – you know exactly how much you’ll owe, so it can be considered as part of your ‘fixed income’ allocation.
Deleveraging may result in lower insurance costs as well. I look forward to selling our rental next year when the lease ends (market willing.) I have no life insurance but if I die there are a few hundred thousand dollars for my family (more once the other house sells) and no debt from my end. My wife already pays our mortgage and I killed off our student loans years ago when they were around 8% (Good luck, not skill, in real estate at that time!) The other benefit is being able to practice part-time, so the idea of doing this work another 20 years or more is not so onerous.
http://www.bogleheads.org/wiki/Paying_down_loans_versus_investing
So hard to decide, if to pay off 2.5 to 3% loans (350k) or invest. I do pay little bit extra like 100 dollars a month. This article made me wonder if I should increase that amount.
I do want to have extra cash, maybe invest when markets are down, maybe let the bank take the risk of the house mortgage and protect against inflation.
I do know I would have paid any loans over 5%. Around 3% it feels such an awash. Still cant decide what to do.
One option is to invest the extra money in a separate “loan” account. This cash can be used at anytime to pay off your loans. The benefit here is that you get to invest until you reached a sum large enough that paying off your loans actually has a dramatic change.
For example, lets say you have a 350K mortgage at 3%. That is $1,475 per month payment. By paying even 50K into the loan does nothing to change your cash flow. But investing $50K and contributing to that investment over several years can get you to a place where you can just sell your investment and pay off your mortgage. Now the payment actually does something to your monthly cash flow.
thanks, sounds like a good advice, a good time to sell would be when markets are high, though so hard to predict, if they are going to go any higher.
Our numbers a few years back looked like yours with 350K on a 15 year mortgage at 3.125%. We wanted to have it paid off in 10 years. We ran our numbers and investing “beat” paying it off by 15K given the small amount invested monthly over only 10 years. For 15K over 10 years, we decided we would rather have the mortgage paid off. Before we decided to choose paying it off, we did have a fully funded emergency fund (1 year for us), are taking full advantage of all tax deferred retirement options, have college funded for kids, and have some taxable investing as a buffer. It was not an all or none decision for us. We do keep some taxable investing going and will use it near the end of the mortgage as a lump sum payoff. We are ahead of schedule already and it feels great.
We started the decision to pay it off slowly by just adding the amount of one monthly payment per year divided into our monthly mortgage payments (which in your case is probably more than $100/month). We didn’t even miss the amount in our budget. From there, we decided to pay off more in principal annually than interest. From there, twice principal, etc. If you start down the pay off road and don’t like it, you can always go get another mortgage and increase your debt load! Good luck.
I deleveraged beginning at age 36 after finishing fellowship. I took the highest paying job I could find wanting to pay off debts as fast as I could. It was a good job with good people, but I was on call just under 50% of my living hours and lived in what is considered a very undesirable location. It took 2 years. I did max out my tax-deferred retirement available to me as a W2 employee, but all other money after paying bills went to debt. We lived low on the hog by physician standards.
Was it worth it? We then moved closer to family into a small $200k house and took a job that looked good on paper. Was going to save up a bunch of money and retire early. The job was awful, sole destroying, and as bad as you can imagine. Then it dawned on me – I could just quit. I could certainly pay my bills with just some locums until I find something better. So I did. Not only did I sleep well at night, but I am amazed at the opportunities that came my way after I gave notice.
The numbers for us are: started with $1.1M in debt (half loans, half mortgage) and finished with $0.00; started with zero assets and went to $120K in retirement plus two $9,000 cars and $10k in the bank. Our monthly bills are about $7,000 (which includes good life and disability insurance); the salary was about $575k per year. Could I have made more by investing – maybe – but the peace of mind and freedom I have now is worth more. Thanks for the article.
Are you part of a physician couple? My wife and I are looking at doing exactly this down the line when we finish residency. Thanks for sharing, it’s always good to see people on here that have made good decisions and ended up in a place they are happy with.
$1.1 Million in two years on $1.15M is pretty incredible I think. Nice work. Hope you find your dream job now that you’re free of that massive burden.
Well, it involved selling/down sizing our real estate situation. My spouse is not a physician. She ran a small business that helped with taxes a bit.
Congrats!
I suspect people will forever be debating the merits of deleveraging. Mathematically, it may not be the best decision.
From my observation, most doctors with mortgage/student loan debt do not live a modest lifestyle and deploy their “excess” money for investing. For myself, I rationalize deleveraging as a pure discretionary expenditure on peace of mind and freedom. I’d rather spend my money this way than McMansion, yachts, club memberships, exotic cars, etc.
Here’s one way of looking at leverage. Suppose that we take an average mortgage, with a 20% down – this is a 5:1 leverage. What does that mean? If the real estate prices go down by 20%, you will lose 100% of your investment (on paper, and of course the opposite happens if the prices go up). So if you have a $100k down-payment on a $500k house, house prices fall 20%, you lose $100k, or your entire investment (100%). If we consider a S&P Case-Schiller index (the index of real estate prices) to be a proxy for the price of an average house, the 5:1 leverage makes investing in such an index to be more risky than investing into S&P500 given the leverage.
The biggest risk of such leverage is having to sell early. An average house gets sold within 5-7 years, and given how much turnover there is right now, it is not unreasonable to have to sell a house much earlier than anticipated. Having this type of leverage makes an expensive house into a very risky investment. This is another component of leverage that has to be taken into account.
I am deleveraging my life because I don’t know what tomorrow holds. What happens if I want to make less money and live a more peaceful life? What happens if I want to take a job that pays less, but has a greater equity stake? I cannot just sell stock whenever I want get that 6-8% return that the above have been arbitraging.
Other benefits include needing to hold less insurance, no origination fees on cash home purchases, and minimal cash flow requirements to pay the bills.
All that being said, I have a long way to go before we are debt free. I know it will be easier for me personally to strive to pay off debt than arbitraging arbitrary numbers.
Very well said!
OK so I am very new at this. Thank you WCI for this website. It has been my personal finance 101.
So, having read the post and all the above comments, what do you think about the following:
When faced with the choice of what to do with “extra money” (i.e. positive cash flow remaining after taxes, insurance, monthly expenses (hopefully kept to a frugal standard), minimum debt/liability obligations (e.g. student loans, mortgage, car loan, practice loan, etc.), maxed-out tax-protected retirement accounts, topped-off emergency fund, and significant contributions to a diversified, primarily index-based taxable investment portfolio), one might follow the following algorithm:
1. Pay off High Interest Debt (e.g. >6%)
2. If your debt-to-income ratio is high (e.g. >40%), then deleveraging should take priority to reduce the risk of being unable to service debts in the case of income instability, especially in the context of large student loans, since these cannot be discharged through bankruptcy proceedings.
3. If you have a reasonable debt-to-income ratio, and no High Interest Debt, then take a personal account of how much “debt freedom” means to you. If the burden of debt distresses you, consider putting the “extra” towards deleveraging, knowing that the “return” on that is a sense of financial freedom.
4. If, after reflection, there is a reasonable chance that instead of investing, you (or your spouse/kids/etc) will spend the extra money on needless expenses, put the money towards your debt before you waste it.
5. If you are comfortable managing a debt load with low rates, and have a proven track record of success in personal investing, then consider putting your extra money towards your taxable investments, which will likely, if managed properly, grow at better rates than your debt, understanding that the increased projected returns are balanced by risk-tolerance, and risk-tolerance should generally decrease as one approaches retirement (i.e. investing newbies should probably put their extra money towards debt until they are very comfortable in managing their portfolio and a sense of experimentation has cleared).
Good comment. I like it.
Looks like you have a good grasp of it. Like WCI says many times over the blog, just don’t forget that your risk tolerance might not be as good as you think until you see your money drop. If you’ve been through a downturn and didn’t change your plan, then you know yourself pretty well.