Reflections From Lake Powell
I had a great time at Lake Powell over Labor Day weekend. Our little boat ran great, none of the kids got hurt, and the weather and water were perfect. We explored some sweet slot canyons, basked in the sun, and I even figured out how to clear the entire wake on my toe side. I was particularly relieved after one particularly bad wipeout that I could still see out of my right eye. I was positive it had just been pushed out the back of my head.
I wrote my posts for this weekend ahead of time and had them published automatically while I was gone so I was pleased to see upon my return that the blog had hit the magic number of 100 subscribers. Give each of yourselves a pat on the back for a job well done! Here's to hitting 1000!
Aside from the usual boat envy I experience down there (this time it was for a sweet houseboat with a helicopter sitting on a landing pad on the top of it) , I reflected on what a wonderful thing it is to have money. I'm not talking about enough money to buy a helicopter to park on your houseboat (although that would be cool). I'm talking about enough money to do what you want to do. I'm talking about enough money to be able to splurge on a trip like that and not have to worry about being able to pay the mortgage AND the electricity bill. Enough money that your finances don't keep you from doing something you want to do when you want to do it. It is a wonderful thing when you have both the time and the money to do anything you want (within reason). However, getting to that point requires a few things. First, it requires a good income. Second, it requires the ability to manage it well. Both of these things require the ability to delay gratification (which most docs are quite good at.) They also require the acquisition of some important knowledge. To earn money in medicine you spend years learning and training. To manage it, you also need to spend years learning and training. The good news is it doesn't require 80 hour weeks to learn to manage money. More like 1 hour weeks. But you have to do something like spend some time on a good blog, at a good forum, or even better, read a good finance/investing book once a year.
On the way home, I was surfing the radio stations and ended up on Dave Ramsey's financial advice show. I was impressed while listening to him answer a caller's question that there are a lot of questions in personal finance that don't have one right answer. The caller's question was basically this:
I'm 43 years old, have a 6 figure income, $750K in retirement accounts, $300K in taxable accounts, a $300K mortgage, and no other debt. I plan to retire in 10 years. Should I pay off the mortgage with the taxable account money?
Dave's answer, as those who have listened to him could easily predict, was to pay off the mortgage. His oft-used example was “If you had a paid off house would you take out a mortgage to invest it in a taxable account?” The answer for most of us, of course, is no. He then goes on to explain how money is fungible and that it is basically the same thing. He also suggested that when someone has a paid-off house they are more likely to make more money at work and make better career decisions. Now, I'm not sure there's any data to support that, but I thought it was an interesting concept. I suppose it could even be argued that someone with a big mortgage might actually earn MORE money because he feels a need to work harder due to the big weight being held over his head, but I can see how a big mortgage might limit career options. Consider the worker who has to turn down a raise because it would require him to move away from a house he is underwater on.
The more I thought about it, the more I realized the question is a complex one. The correct answer from a behavioral finance point of view is not necessarily the correct answer from a mathematical point of view. For example, Dave didn't ask the fellow what his tax bracket was, what the rate on the mortgage was, what the range of expected returns on the taxable portfolio were, what the cost basis on the current taxable holdings would be, or even what his risk tolerance was. All of these are important pieces of data required to arrive at the correct mathematical answer. I'm not even convinced he nailed the answer from the behavioral perspective. I mean, if paying down a mortgage instead of investing is such a good idea how come everyone doesn't put every dollar they can toward their mortgage until it is paid off and THEN start investing. The reason is that it isn't a wise thing to do, at least for most people.
A mortgage may be very cheap debt. My current state/federal marginal tax rate is 33%. My 15 year fixed mortgage is 3.625%. My after-tax mortgage rate is 3.625%*(1-33%)= 2.43% (I can fully deduct all of my interest). Inflation is currently 3.63%. So even if my investments earned 0% after taxes and investment expenses, I'd STILL be better off mathematically not paying off this mortgage any faster than I have to. Obviously, I expect my portfolio to return a little more than 0%. Some say investing while holding a mortgage is a kin to investing on margin. Well, that's not quite true, since mortgages don't get called by the bank when the stock market plummets. In fact, as long as you can service the debt (which basically means either work or collect on your disability insurance policy) a mortgage (at least at current rates) is a loan to you at extremely favorable terms. Heck, at current rates you pay half the interest on mortgages as on federally-backed student loans!
Also, while not as important in the case of Dave's listener since the money discussed was in taxable account, there are tax advantages that could make a physician investor lean toward investing rather than paying down a very low rate mortgage. For example, if you paid down your mortgage instead of maxing out your 401K, you could miss out on decades of tax deferment and tax-free growth. Even in a taxable account, realizing long-term capital gains (or worse, short term gains) to pay off a mortgage, when that money could be used for your charitable deductions (without you or the charity paying tax on it) or passed to your heirs (with the step-up in basis at death) would be foolishly paying taxes that didn't actually have to be paid.
The other reason Dave's question is hard to answer, ignoring for now the behavioral aspects and the mathematical aspects, is that it is impossible to predict the future. In March 2008, the right answer would have been to pay down the mortgage. In March 2009, the right answer would have been to invest (in stocks) in the taxable account. Investing is more about managing risk than anything else. Paying down a mortgage (or other loan) is a guaranteed, risk-free, rate of return. Investing, of course, is not. You need to be paid (or at least expect to be paid) more to take on more risk. If it doesn't appear you are, then take the guaranteed investment. I had a residency classmate call me on my way to Lake Powell asking if I thought he should pay off his 8% fixed second mortgage. I told him if I had a guaranteed 8% investment I wouldn't be putting a dime into risky investments until I had maximized that opportunity, especially given our current low interest rate environment.
In conclusion, remember Taylor Larimore's fine advice that “There are many roads to Dublin.” Financial questions don't always have one right answer. The correct answer varies by the person (behavior), by her particular financial situation (mathematics), and, sometimes, by the unknowable future. Most importantly, don't bury the front tip of your wakeboard at 20 miles an hour.