By Dr. James M. Dahle, WCI Founder
By the time you read this, my family will have been completely debt-free for about three years. From the time I was 18 until the time I was 42, we had some sort of debt, usually either a mortgage or even when renting we had the $5K student loan I took out as a college freshman. We're (fairly, in my opinion) ignoring the current month's expenses placed on credit cards (always paid off automatically), the leverage used by limited partnerships/LLCs we invest in (since our loss is limited to our investment), and the leverage used by publicly traded companies whose stocks we own via index funds. Everything we now buy, including our home renovation (the most expensive purchase of our lives), we buy with cash. The White Coat Investor, LLC has never had any debt and we plan to continue to grow it debt-free.
That's not to say I've never tried to use debt to our advantage. All three of our homes we have bought with a mortgage. My last year of residency we funded our Roth IRAs using a 0% credit card that we would pay off as an attending a few months later. We pulled money from our accidental rental property in order to purchase our current home. We drug out our final mortgage a couple of years longer than maybe we had to. I say all that to point out that I'm far from innocent of the “financial sin” I'm going to describe today. Let me explain.
I often suggest people pay off their debt or that they are over-leveraged in a blog post, on a forum, on social media, and even in real life. While most agree with me, there is usually someone who pipes up to give some pushback. The argument usually goes something like this: “It's stupid to pay off a 2%-4% debt because you expect your investments to do better than 2%-4%.” I used to believe this argument too. It's easy to do so because mathematically it is correct. The older and wealthier I get, the more I see serious flaws in this argument, and I'd like to discuss them today because the argument is so darn common, even among people who are debt-free!
I've started pushing back on these people (and no, they don't like it) by asking them two questions:
- Are you rich yet?
- If you are, did carrying debt at 2%-4% while investing contribute to any significant portion of it?
The answer to number one is almost always no, but even if it isn't, the answer to number two is also almost always no. I fully acknowledge that there probably is somebody out there who would answer yes to both questions. But they are surprisingly rare. I run into so few of them that I'm not sure I can even describe them for you, but I postulate that most of them are real estate investors who maintain reasonable loan to value ratios of 50%-66% on their rental properties. The person advocating for more leverage is usually a 25-year-old with lots of debt, few assets, and little experience. It never seems to be the 60-year-old multimillionaire I'd like to emulate.
14 Reasons You're Thinking About Debt Wrong
Let's list out some issues with this argument. For purposes of our discussion today, let's define the argument as “You should not pay off 2%-4% debt any faster than you have to because the long-term expected return on your overall portfolio is higher than that.” Now, let's debunk it.
#1 Justification
The majority of the folks advocating this approach are simply using it as justification. “I'm not paying off that debt because I COULD invest at a higher rate.” They aren't actually doing it. It's a behavioral problem. In fact, having many kinds of debt (auto, credit card, etc.) reflects a behavioral issue, not a difficulty in understanding math. So the first thing I ask is “Are you actually investing the money that would go toward paying off that debt?” Too often, the answer is no. They are neither paying off their debts nor investing with that money—they're spending it.
Now, do I expect you to live a spartan existence until your final student loan and then mortgage payment is made? No, I don't. But every time you catch yourself not paying off your debts because the interest rate is low I want you to look around at everything you're buying and ask yourself if you can justify borrowing at 3% to buy it. I bet you'll spend a lot less, get out of debt a lot faster, build more wealth, and have more freedom in your life.
#2 You Are Ignoring Risk
Lots of people who make this argument simply look at two numbers and choose the higher one. If the stock market has averaged 10% a year historically, and the student loan is at 4%, you don't pay off the debt. However, the reason long term stock returns are so much higher is because they are risky. Without getting into a long, drawn-out philosophical discussion of what risk is, the fact remains that while the expected return on stocks might be 6%-10%, there will be many years where the return is much lower. It is not a guaranteed return. Thus, you are comparing the guaranteed return available by paying off your debt to a non-guaranteed return available by investing. That's apples to oranges. You must risk adjust the returns. You must compare the riskiness of the investments. Since debt paydown provides a guaranteed return, you should compare it to an investment that provides a guaranteed return, such as a Certificate of Deposit or Treasury bills. What do those pay? 1%-4% (and mostly 1%ish these days). Exactly the same as paying off that low-interest debt of yours.
#3 People Don't Understand How Taxes and Debt Interact
Here's another big issue. Lots of people aren't actually using the right numbers. When you pay off a debt, you're getting an after-tax rate of return equal to the interest rate of the debt. When you invest, the return is generally subject to taxes. You must tax-adjust both numbers before making a comparison. Consider a doc with a 40% marginal tax rate earning 3% on a CD while carrying a non-deductible debt at 2%. After-tax, paying off the debt gives you a return of 2%. After-tax, that CD gives you a return of 1.8%. That doc is looking kind of dumb now.
A similar issue comes up with regard to the deductibility of interest. Many attendings are shocked to find out they can no longer deduct the $2,500 per year in student loan interest that they could deduct as a resident. Sorry, that tax break isn't available to high earners.
Likewise, many people think their mortgage is tax-deductible but then take the standard deduction. Newsflash! If you don't itemize on Schedule A, neither your mortgage interest nor property taxes are deductions. Since 2018 with the new, higher standard deduction ($12,400 Single and $24,800 Married Filing Jointly in 2020), a lot fewer people, even some high earners, are itemizing. And even if you do itemize, it isn't like that first $24,800 is actually deductible. Really only the amount above and beyond that $24,800 is deductible and should be used to reduce your effective interest rate.
This all ignores what usually happens, of course. Consider a high-earning doc who recently posted his situation on the Bogleheads forum. He had an $80K 2.4% student loan and an 11.5 month emergency fund earning 1.6%. It takes great amounts of tact to point out mistakes like that to otherwise very intelligent, high-earning people.
Tax advantages are also one of the reasons I am hesitant to tell people to pay extra on their low-interest rate 15-year mortgages or 5-year student loans before maxing out their retirement accounts. Those advantages will often compound for decades. But the point is that you need to understand how taxes affect your debts and your investments before you can really run the numbers on a mathematical decision.
#4 Can't Go Bankrupt Without Debt
I see people going through bankruptcy from time to time and it never looks like they are having much fun. When we make these calculations and decisions to carry debt on purpose, we generally assume life going forward will be pretty hunky-dory. We assume the present situation will carry on indefinitely. However, that doesn't always happen. Divorce, disability, illness, death, COVID-19, drought, war, earthquakes, hurricanes, job loss, business failure, and all kinds of other financial catastrophes occur. Some can be insured against and some cannot. I am amazed how many financial gurus out there have gone bankrupt or been foreclosed on. Maybe they learned their lesson and maybe they didn't. But if they didn't, I certainly don't want advice from them. At any rate, without debt, you can't go bankrupt. It's simply impossible. Nor is there any point, since the point of bankruptcy is to restructure or wipe out some or all of your debts. The likelihood of this happening to you is low, but it isn't zero unless you're debt-free. You can be broke, but you can't be bankrupt.
#5 You Carry Too Much Cash
People with debt often carry more cash than people without debt. Consider the classic 3-month emergency fund. Let's say your expenses are $10,000 a month, so you have a $30,000 emergency fund. But your expenses include $800 in car payments, a $2,000 student loan payment, and a $2,200 mortgage payment. Imagine, if you will, a life without payments. Now, what are your mandatory expenses? $10,000 – $800 – $2,000 – $2,200 = $5,000. Now your emergency fund can be just $15,000 and you can invest the other $15,000. Instead of making things complicated, just ask yourself “Would you rather earn interest or pay interest?”
#6 Less Disability and Life Insurance
#7 Use a More Aggressive Asset Allocation
People only have a certain amount of risk tolerance in their life. If you use it all up on leverage risk, you are less likely to have any left over to use elsewhere. Perhaps paying off your debt would allow you to tolerate a more aggressive asset allocation while still sleeping soundly at night. The long term benefits of that are likely to overwhelm any potential arbitrage between your car loan interest rate and rate of return on a few thousand dollars.
#8 Take More Risks at Work
Similarly, someone without debt hanging over their head can take more risks at work. They feel more confident asking for a raise. They feel more confident leaving the job (or just threatening to leave the job) for another. They have more confidence telling an administrator “I'm not going to do that”. They have more control over their job and enjoy it more and can thus stay at it for longer, earning the financial rewards of doing so.
#9 Take More Risks with a Side Business
Being debt-free also allows one to take a lot more risk in business. Entrepreneurs often talk about “runways”. The idea behind a runway is to make it as long as possible to give “the plane” (i.e. the business) the greatest possible chance of getting off the ground before crashing into the forest at the end of the runway. Debt, like investor money from venture capital, shortens runways. A boot-strapped business that pays for itself as it goes along has an infinite runway. It can just keep going for years without really getting off the ground. I had a similar experience with The White Coat Investor. It really took 4-5 years before I could justify the time I was putting into it instead of just seeing more patients. Imagine if my family had needed that early WCI income to eat? I would have had to close up shop long before the plane got off the ground. Imagine how different your business decisions might be when there is a big debt payment to cover every month. How might those decisions affect the long-term viability of the business?
#10 Simplify, Simplify, Simplify
A little too much simplification?
“The price of anything is the amount of life you exchange for it.” These famous words from Thoreau can dramatically improve your financial life. Trying to maximize your leverage does precisely the opposite. Imagine how much time and energy is spent trying to shift around a dozen credit card debts, two auto loans, an RV loan, 17 student loans, and a couple of mortgages. That is time that cannot be spent making money or even enjoying yourself. One of my favorite things to ask someone who thinks using a 2% auto loan is a good idea is “Would you buy a garbage disposal on payments in order to invest? If not, why not? It's the same thing.” How about a pack of gum? Where do you draw the line?
Pay off your debt, simplify your life. There's a reason that those who do often describe a massive burden being lifted from their shoulders. It is similar to the reason that so few people who become debt-free go back into debt. That is always an option. Just because you pay off your mortgage doesn't mean you can't go get another one if you don't like being debt-free.
#11 You Have to Care About Numbers That Don't Matter
There are important numbers in personal finance:
- Net Worth
- Income
- Savings Rate
- Rate of Return
- Effective Tax Rate
- Marginal Tax Rate
But people who are in debt don't seem to spend very much time on the most important numbers. They seem much more concerned about other numbers that are, in the big picture, far less important.
- Credit Score
- Credit Limits
- Interest Rate
- Loan to Value Ratio
People without debt, or at least those with a solid plan to eliminate it, just don't care about that stuff. They solve problems in different ways. For example, a few months ago we were trying to buy a bunch of books for the WCICON20 swag bags, but the transactions started getting declined. It turned out the credit limit on the company credit card was just $20K (had been for years because we never had a need to increase it). I was annoyed to have to call the credit card company to ask for an increase. It shunted me into an automated menu. “How much profit did the business have in the last year?”, the computer asked. I named a seven-figure amount. It asked a few more questions and then told me it would get back to me in six weeks. It was truly comical. Even talking to a real person didn't change things.
“Can I just write you a check to put on the card so we can finish these purchases?”
“Yes, you can do that.”
“Oh no, we can't take that. But you can pay off the $18K you have on there today with a transfer.”
It was a bizarre conversation. But we did get the books ordered and presumably the credit limit will eventually be raised before it comes time to buy stuff for WCICON21. Or we'll just write a check.
#12 The Spiritual Argument
Many of the most popular religions of the world have a very anti-debt stance. Muslims don't like borrowing or even earning interest and often seek out “shariah-compliant” mutual funds. Jewish prophets condemned the charging of interest, at least to other Jewish people. Christians hear scripture each Sunday such as:
- The wicked borrow and do not repay
- Suppose one of you wants to build a tower. Won’t you first sit down and estimate the cost to see if you have enough money to complete it?
- The borrower is slave to the lender.
You may or may not care what a supreme being thinks about your decision to be in debt, but if you do, it's one more reason not to keep it around any longer than you have to.
#13 Liquidity Is Overrated
I occasionally hear a similar argument, that I don't want to pay off my debts in case something comes up. “I want to be liquid.” The thing about liquidity, though, is that you simply need “enough”. More than enough doesn't do you any good. In reality, as you build wealth, a large portion of that wealth is likely to be quite liquid (ask yourself how many $100 bills you could stack on your kitchen table one week from now if you absolutely had to?), and the amount of liquid assets increases over time. In fact, like most wealthy people, I have so much liquidity I am happy to give some of it up if I can be adequately compensated for doing so. Retirees don't need emergency funds. Their entire nest egg is their emergency fund. But even when you are just starting out, you define exactly how much liquidity you need. It's called an emergency fund. Whether you decide you need one month of expenses or six, once you have that, the rest can be used to pay off debt without concern for illiquidity.
#14 Multi-Millionaires Don't Do This
If you want to do something difficult, it is generally wise to find someone who has done it, ask them how they did it, and copy them. If you want to get rich, find some rich people, and ask them how they did it. I do this all the time. You know what they tell me? They tell me the following were the keys:
- Get enough education to get a high-paying job
- Own your own job and/or start a business when possible to maximize your income
- Save a large percentage of your income by being relatively frugal
- Invest it in some reasonable way
That's it. They don't say “get a cash back credit card and try to maximize it”.
They don't say “buy a car using a 0% interest rate“.
They don't say “swap your brokerage or bank account around frequently to score transfer bonuses”.
They don't say “use airline miles for all your travel”.
They don't say “drag your student loans and mortgage out for 30 years”.
In fact, as a general rule, when you ask them how they managed their debt they all paid it back much faster than average. Sometimes they even feel a little guilty about doing so, saying “Maybe I could have done better if I had just invested that money instead of using it to wipe out debt”. But you know what? They probably couldn't. Because the same drive that causes someone to work hard, earn lots of money, save a ton of it, and invest it well also drives those people to pay off their debts quickly. I feel the same way when I look back on the few times I tried to use debt to improve my financial situation. In two situations, I used it to buy houses I shouldn't have bought in the first place and lost money on both of them, at least after transaction costs. Funding Roth IRAs with a credit card? Didn't move the needle. The amount of money we made doing that is a rounding error. Dragging out the mortgage for a couple extra years to arbitrage it? Not even 0.1% of my net worth. Do yourself a favor–focus on what really matters and don't get distracted by gimmicks like I did.
Taking on debt to invest sounds so intelligent, even if it doesn't feel right. If you find yourself wanting to pay down debt, but feeling stupid about doing so, I would encourage you to read the infamous 2008 Market Timer Thread, where an incredibly intelligent person decided to “mortgage his retirement”. The outcome, in retrospect, was not terribly surprising, but to read about the experience as it unfolds in real-time is enlightening. The most impressive thing is how smart he sounded…until he didn't.
The Best Way to Use Leverage
Now, after 3200 words, it's time to get on to the point of this entire blog post. If, despite the above diatribe, you have decided you need or want to add leverage risk to your life to help you reach your financial goals a little faster, this is how I think you should do it.
Don't ask yourself, “Can I earn a higher rate of return than I am paying in interest on this purchase?” with every single little purchase you make. This is the way most people do it and what I would call the wrong way to think about debt. I think you should ask yourself “What is the correct amount of leverage I should have in my life?” (i.e. the right way to think about debt) and then make adjustments as needed to maintain that level of leverage. Obviously, you want the terms on any loans you do have to be as good as possible (a 25% credit card loan or a payday loan is pretty much always bad), but really the key is the amount of leverage. Where does this leverage come from? It can come from mortgages, low-interest-rate student loans, a 0% car loan, the IRS, or even margin loans against your portfolio. The idea is to avoid “oppressive debt” while taking advantage of debt with favorable interest rates, terms, and tax advantages. But most importantly, to have the proper amount of debt.
So how much is the correct amount of leverage? Well, if you ask the guy who wrote the book on it (The Value of Debt by Thomas Anderson), the proper amount is between 15% and 35% of your assets. So if you have $1 Million in assets, the amount of debt to maintain is $150-350K. So if you have a $5 Million portfolio, carrying around $1 Million in debt might boost your returns a bit. Less than 15%, you're not going to move the needle and you might as well pay it off. More than 35%, you're taking on too much risk. I almost never run into docs whose debt ratio is between those numbers. Usually, it is dramatically higher.
Consider a dentist who just came out of dental school ($500K in student loans), bought a house ($500K doctor mortgage) and a practice ($500K practice loan). Maybe she has $1M in assets between the house and practice. What's her ratio? 150%. About 5 times the maximum recommended debt. Even Anderson, perhaps the biggest debtophiliac out there, thinks she needs to get a big chunk of that debt paid off ASAP. In fact, he thinks that most people really can't handle any debt safely. But if you're going to do so, I think this is the approach to take.
So the next time you have someone tell you to carry your debt around in order to invest, ask them “Did it work for you? Is that why you're a financially independent multi-millionaire?” I'll bet they don't like those questions and I'll bet the answer to both of them is no.
What do you think? Are you incorporating a defined amount of leverage into your financial plan? Are you guilty of justifying your debt due to low-interest rates? How do you think about debt? What's your debt ratio (debt/assets)? Comment below!
This post articulates and supports my feelings about eliminating debt. Although everyone may not agree, this is one of the best posts I have seen clearly arguing the case for living life debt-free. I hope to join the club within the next year!
I couldn’t agree more. I think people underappreciate how much being debt-free allows you to take on more investment risk (your #7) and the way that having no mortgage (or student loan or vehicle) debt increases the amount of your cash flow available each month for investing. I think the other point that becomes more apparent later in an investing career is that prolonging a home mortgage doesn’t seem to move the needle. At this point if we mortgaged our homes to the limit it might add 10-15% to our investible portfolio and that just doesn’t provide enough incentive to move so far backward in our financial stability.
“Did it work for you? Is that why you’re a financially independent multi-millionaire?”
Awesomeness!
Perhaps the best article you have ever written. I was a “cross-over” study myself. I used to carry debt, but my progress was minimal. A couple decades ago, I went hardcore the other way. An amazing thing happened….my net worth increased, my life quality increased, my stress decreased. Eventually I was able to tailor my professional life to a form which brings happiness.
Everything you said is true. Especially about “risk”, and “guaranteed rate of return”. Two factors that should be emphasized any time this discussion is held.
Very good. My wife and I have struggled with the over saving if cash vs paying off the mortgage very fast question…it somehow feels more “secure” to have extra cash in hand for house issues, travel, medical, etc. But I could probably payoff the 3.5% mortgage this year if I wanted to (vs over the next two or three years). It’s not logical or mathematically correct but hard to overcome this desire to hoard more cash especially after the covid scare earlier this year. Thoughts?
This is exactly what I’m struggling with right now. Our only debt is a reasonable mortgage balance that I actually just refinanced to 2.8% 30 yr fixed. I want to have a paid off house, but I also want to see my taxable account grow. I am having a hard time deciding how to approach it. And the recent pandemic has made that decision a lot tougher.
I went through the same dilemma about 15 years ago, Hightower.
I decided to split the difference; I paid more each month on the house AND invest more. This went ok for a few years, but the mortgage hanging over my head continued to bother me. That’s the point I went super-aggressive and paid off the mortgage in about 3 years.
Life is just a lot simpler. The monthly budget is REALLY easy w/o a mortgage. I highly recommend it.
Loved this post! This argument comes up so often. I like to advocate for paying off debt, no matter what rate, aggressively, saying that each dollar spent on debt paydown will increase your net worth by one dollar. Of course someone always jumps up to claim that’s not true and it’s a zero sum situation. Then I ask them what they spent their money on last month instead of debt paydown. It’s almost always spent on some luxury and rarely actually spent on investments. So it’s not zero sum, that dollar that should have gone to debt now went to a car loan or some expensive toy that decreases your net worth.
Keep it simple stupid – just pay down your debts!
The Prudent Plastic Surgeon
Great post. Once you pay off all debts you realize how achievable the 25X nest egg actually becomes. With no debts FI is much easier to obtain.
Awesome post. #7 is a big one for us. Having a paid off mortgage with a nice chunk of change in our home value helps a lot with allowing us to have a relatively risky allocation for our age. And the extra cash flow to invest is great too.
Get all the important things right, and the small stuff doesn’t matter.
Churning credit card rewards, slowly paying off smallish loans, travel hacks: it’s all small stuff. I’ve gladly given up these inconveniences in favor of simplicity.
Great post! I cannot describe the energizing feeling we experienced when we paid off our mortgage earlier than required. We ended up saving more each month because we were just so motivated with having no debt.
I do think that there are some folks who have NEVER in their lives been without some kind of debt. That is their normal and probably what they saw and heard growing up. Many justify a mortgage as “good debt” versus a credit card bill as “bad debt.” There is no such thing as “good debt”.
I agree 100% Bev.
I often say all debt is bad; some debts may be better than others, but all debt is bad.
I’m sure many will disagree (I don’t really care), but being debt-free simplifies everything.
Hear, hear! Brilliantly written.
Disha
My brother had been managing our investments and when I asked him about paying off my mortgage before my husband got out of the military, he urged that we refinance and invest in market! I did some back-of-the-napkin calculations like you review and decided back then the 4% return, even with our mortgage tax deduction at that time, plus that much less money to worry about every month as my husband’s pay went from active duty to pension, decided it for us. I haven’t regretted it at all, and as described it made it easier for us to quit jobs and take on, not businesses, but other expensive projects with long runways. Just calculating our monthly income needs MINUS $3K mortgage was delightful. How much more so with a larger mortgage!
Our debt number is about 11%. I have contemplated paying off our mortgage (our only debt), but I never have because of many of the excuses mentioned in this post. Very well done with this post. Generally I despise leverage of any kind.
However, my primary issue is that I need to sell stock and pay capital gains in order to pay off the mortgage. My turnover in my taxable portfolio is usually very low. Perhaps one day when I make a sale, I will allocate the proceeds to eliminate debt from out lives.
TPM, You do not need to sell anything to pay off your mortgage. Just decide it is a priority and every month make a bigger than required payment out of the cash you made that month. You will be surprised how fast that pays off the house. Every extra payment goes to principal, making your regular payment more effective each month. It becomes a snowball. I made that decision and paid off my house 19 years ago. I have very much enjoyed not having that house payment over the years.
Dr. Cory S. Fawcett
Financial Success MD
Love this approach to helping others. Smart – smart – smart.
As a WCI reader, this may not be the case, but I hope and expect that you are investing in stocks etc. above and beyond the tax-sheltered retirement accounts. So just put all the money you might have put into a taxable stock account or Bond account instead towards your mortgage. of course you may be one of those guys able to sock away 50% of your income in retirement funds running 19 businesses…
I’m a huge fan of paying off debt, but one issue I’ve struggled with is how to account for paid off debt (like a mortgage) in my asset allocation, and I’d be interested in others thoughts.
Let’s pretend you have a $1M investable portfolio in a 60/40 stock/bond split, and a $400,000 mortgage. Many people (and this article) would argue that you should take the $400K you have in bonds and pay off the mortgage. I agree, and that is exactly what I did. I have never regretted it. However…
Now, what is the new asset allocation? You have $600K in stocks, and a paid off $400K house. While paying it off was a “bond equivalent,” the house does not have the same risks/benefits as a $400K pile of bonds.
Do you count the $400K house as a “bond equivalent” in your portfolio? In reality you have $600K in stocks and $400 in a house.
Do you count it as real estate? Now you have a 60/40 stock/real estate portfolio, which is certainly not mainstream.
Do you not count it at all? If so, then do you rebalance and take your $600K in stocks, sell $240K, and buy bonds? This just forced you to take less risk.
WCI focuses a lot on “following your written investment plan” but this wrinkle causes interesting dilemmas when you try to do just that.
What did I do? I’m currently 70/20/10 stocks/bonds/real estate and count the paid off house toward the real estate 10%, but I’d be curious to hear others thoughts on this.
IMO, you don’t count your house in your portfolio. Your net worth, yes, but not your retirement portfolio. So with $600k in stocks remaining, simply rebalance to 60/40.
JMS, Do not count your personal residence as anything in your portfolio, it is not an invested asset, it is a liability. In a budget it shows up in the expense category not the investment category. Now you spent all your bonds, don’t sell any stock to rebalance, just make all your new investments bonds until the ratio gets back to your desired target. Also you should celebrate this incredible milestone. Not everyone has the status of owning a house free and clear. I hit that mark 19 years ago and have never regretted the decision to pay off my house. Congratulations.
Dr. Cory S. Fawcett
Financial Success MD
While I count the value of my home in my net worth, I don’t count it in my portfolio. Paying it off was a separate goal with a separate asset allocation than saving for retirement. While paying off a mortgage is the same as investing in bonds, owning a home is not the same thing as owning bonds.
I agree, a home should not be considered a part of one’s retirement portfolio.
A retirement portfolio is used to cover one’s retirement expenses. When the mortgage “goes away”, your expenses are reduced so your retirement portfolio becomes a higher multiple of your expenses.
I’m a multimillionaire and have had no debt in over a decade. We buy cars and everything else with cash, and always have, even before we had any wealth. If we ever buy another house it will be in cash as well. I agree with 99% of this very readable and well articulated post. But I will quibble with your two questions. “Are you rich yet?” doesn’t address the debt issue in my opinion. At one time Warren Buffett wasn’t rich, but that fact isn’t pertinent to judging his money acumen. It comes across more as an ad hominem attack on a debt user. Similarly asking a rich person if leverage contributed to his wealth doesn’t really address whether it is a sound idea or not. My multimillionaire friends would, every single one of them, stop to pick up a ten dollar bill lying on the street. I’ve done it twice on my morning runs. The fact is “found money” did not contribute significantly to my net worth, nor to my friends’ net worths. But is picking up free money a smart economic strategy? Of course it is. I don’t think keeping 2-4% loans that can be easily paid off early is a good idea, for all the reasons you stated. But I don’t think those questions strike to the heart of why. Great post!
I couldn’t agree more with this reply. Even while appreciating the larger point of the original post, the idea of doing anything less than optimizing one’s financial returns just feels alien to me — if you have the discipline to invest what you’ve leveraged, it helps get you to FI quicker. So why knock it?
I’m not sure one can “ad hominem” an anonymous, hypothetical person. 🙂
Even if one wants to be leveraged, there are better ways to do it, like options, futures, and leveraged funds; if you have enough in taxable accounts to pay off your mortgage, you can do so and then replace the exposure with futures at a lower implied rate . These are more complicated then they average investor is used to, but that’s the point: being leveraged is risky and can be complicated, for all the reasons stated above, and you should only do so if you are willing and able to understand what leverage introduces into your portfolio.
I went through the same dilemma about 15 years ago, Hightower.
I decided to split the difference; I paid more each month on the house AND invest more. This went ok for a few years, but the mortgage hanging over my head continued to bother me. That’s the point I went super-aggressive and paid off the mortgage in about 3 years.
Life is just a lot simpler. The monthly budget is REALLY easy w/o a mortgage. I highly recommend it.
The following are some comments about leverage.
Many make the analogy that the stock market is a bit like a casino, except that if you play it right, the odds are in our favor. One can calculate your risk. However, there are problems in stock markets that don’t happen in casinos, and in which risk calculation is difficult and perhaps impossible. Some might call those uncertainties, as opposed to risk. An example would be covid 19. People talk about black swans, and tail risk protection strategies. But for the average retail investor, I haven’t seen good data to support such strategies. However, two ways to protect against uncertainty are to not concentrate but diversify and avoid leverage. I
With both concentration and leverage, there is asymmetrical risk. Perhaps the only two ways for a portfolio to go to zero are concentration and leverage. Perhaps the only way for a portfolio to go to less than zero is leverage.
Volatility is a commonly used surrogate for risk in investing. It’s not without controversy. The case is made that until you get near the time that you have to sell a asset, volatility is irrelevant. Indeed, one hears of volatility harvesting to obtain the rebalancing bonus. However, volatility becomes a risk, with commonly used forms of leverage.
A significant risk with leverage is that you will lever bad behavior. Bad behavior is common; google “behavioral finance”. Perhaps the most common bad behavior that gets levered is overconfidence. Overconfidence and leverage do not mix well..
Another common risk with leverage is the mismatch of asset to liability. Often, the asset is a long term investment, such as stocks. But the liability used to pay for it is is more short term in nature, such as a margin loan. This is similar to the risk that a bank takes on, which can manifest is a bank run. For an investor, it can manifest as a margin call.
However, there is another side to the coin. Perhaps multimillionaires don’t use it, but google Warren Buffet and leverage. Warren Buffett makes critical comments about leverage., but one study found that he had a leverage ratio of 1.55. My guess is that he’s aware that leverage is misused by many, and he doesn’t want to encourage that. However, his own use of leverage suggests that if used carefully by a seasoned investor, it has a role.
When you use leverage, you’re taking on two additional risks. First, there is the risk of the debt/loan itself. Secondly , there is the risk of servicing the debt.
In 2008, there were people whose home equity line of credit got cancelled. Similarly, margin rules can be changed virtually overnight. I know that from personal experience. In both cases, the risk of the debt/loan reared its head.
https://www.tdcanadatrust.com/products-services/investing/investment-lending-services/3for1nomargin.jsp
“Loans are repayable on demand. Loans may be demanded even if there is no default under the Loan & Security Agreement and even if all margin requirements have been met.”
Then there is the risk of servicing the debt. Debt servicing is going to increased your fixed expenses, and that’s never a good thing. Increased fixed expenses mean decreased ability to withstand a financial crisis. If you’re relying on dividends to service the debt, dividends tend to get cut when you least want them to. In 2020, there were restrictions put on US bank dividends. In the UK, bank dividends were scrapped in 2020. If you’re relying on your job to pay the interest, job loss risk may correlate with bear markets. Such a correlation is not to your advantage.
However, its’ hard to make blanket statements about leverage. An example is tax deferral, which is leverage. The government has effectively lent you money. There’s no risk of servicing the debt, as there is no interest. And the risk of the loan is comparatively small. You run the risk that tax rates will increase in the future, such that it would have made more sense to pay the tax now.
https://www.evidenceinvestor.com/what-will-the-recession-mean-for-small-cap-stocks/
The link about shows the ratio of debt to assets for stocks., which is about 0.65. In other words, companies take on considerable debt. Companies wouldn’t do that unless it is profitable. A public company which takes on less debt than is considered optimal tend to become a takeover target.
People talk about inflation hedges, but such hedges are often not as helpful as one would like, when it comes to dealing with inflation. An example would be TIPS. The money invested in TIPS is hedged against inflation, but it won’t decrease inflation risk in the nonTIPS part of your portfolio. And TIPS won’t hedge against inflation in a taxable account.
What you really want is something that profits from inflation. A fixed rate loan would be an example. A floating rate loan, if the interest is tax deductible and your tax rate is sufficiently high, is another example.
Right now, a common complaint from investors is the low return on fixed income. Nominal pretax returns are poor. If you take into account inflation and taxes, they can be negative.
That assumes you’re going long on fixed income. By going long on fixed income, you may have negative returns. But one way to turn that to your advantage is to go short on fixed income. That’s just another way of saying that you’re going to use leverage.
If interest is tax deductible and your tax rate is high enough. leverage can be a form of tax advantaged investing. I’ve seen an analysis where tax deductible leverage was compared to investing in a tax advantaged retirement vehicle, and leverage resulted in a better outcome. Of course, everyone’s situation is different, and this may not apply to you. But both leverage and tax advantaged accounts (IRA etc) are tax shields, with each having their own advantages and disadvantages.
FWIW, I use leverage (margin loan).
Disagree that tax deferral is leverage. You’re just investing the government’s money for them alongside your own.
As mentioned in WCI’s original post, leverage is the only way you can go bankrupt.
For almost everyone, investment is a long term project: one could think of it as akin to a marathon. In this marathon, you commit your savings, and you also take on risks for which you’re rewarded,. Over the long term, such risk taking should result in positive compounding, which will result in you finishing the marathon sooner.
But one could also consider investing as 26 consecutive 1 mile races. In order to succeed as an investor, you must finish every one of those 26 races. If you don’t finish one of those 1 mile races, then you must start the marathon over.
What will prevent you from finishing every one of those 1 mile races? Leverage. Even extreme concentration, minus leverage, is very unlikely to result in the loss of everything. Only leverage can result in the loss of everything. With leverage, you take on risk that may result in you finishing the marathon sooner, but may also result in you having to start the marathon again.
A common theme in investing is reversion to the mean. Investors take on risks for which they are rewarded. But sometimes the risk shows up, and taking that risk penalizes them, instead of rewarding them. An example would be a stock investor in 2008-2009. This is where reversion to the mean over the investment marathon can bail an investor out. You may do poorly over several of those twenty six 1 mile races , but reversion to the mean over subsequent 1 mile races may even that out.
The use of leverage may not result in bankruptcy, but the irreversible negative compounding of leverage may prevent reversion to the mean. You may finish the marathon much later than you otherwise would have.
For me, the 3 asset classes are stocks, bond and cash, and one can go long or short on any one of those classes. I”m a taxable investor, and the only asset class where I can make money is by going long on stocks. But going short on bonds or cash can play a secondary role of increasing my return from going long on stocks. Examples of going short on bonds and cash are mortgages and margin loans respectively.
Cash has the property of being a call option that doesn’t expire on any financial asset. The vast majority of the time, that option property of cash isn’t worth much. But on uncommon occasions, it can be very valuable. On those uncommon occasions, shorting cash can be profitable.
I suspect that WCI think that I should add real estate to those asset classes :-). I can’t resist adding the following:
Asset Management by Andrew Ang p. 427
“Chapter 10 showed that the NCREIF real estate index (despite the artificial rosiness of its raw returns) is beaten by a standard 60% equity and 40% bond portfolio.”
https://epitest.ncreif.org/property-index-returns.aspx
“The NCREIF Property Index is a quarterly time series composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only. All properties in the NPI have been acquired, at least in part, on behalf of tax-exempt institutional investors – the great majority being pension funds. As such, all properties are held in a fiduciary environment.”
From Chapter 10, p.322-323.
“For all of these factor benchmarks, direct real estate does not offer significant returns in excess of a factor benchmark. In fact, the point estimates are negative and around 0.50% per quarter. Interestingly, the factor benchmark consisting of just bonds and stocks indicates that the optimal combination of stocks and bonds to mimic real estate is 35% stocks and 65% bonds.”
I consider real estate an optional asset class. Not sure what time period Ang looked at, but real estate returns tend to be similar to stock returns long term. Less risk? Maybe, but certainly more illiquidity and more leverage generally.
https://academic.oup.com/qje/article/134/3/1225/5435538 Article was published in 2019.
“The annual data on total returns for equity, housing, bonds, and bills cover 16 advanced economies from 1870 to 2015…
In terms of total returns, residential real estate and equities have shown very similar and high real total gains, on average about 7% a year. Housing outperformed equities before World War II. Since World War II, equities have outperformed housing on average but had much higher volatility and higher synchronicity with the business cycle…we find that long-run capital gains on housing are relatively low, around 1% a year in real terms, and considerably lower than capital gains in the stock market. However, the rental yield component is typically considerably higher and more stable than the dividend yield of equities so that total returns are of comparable magnitude”
From Ang,
p. 610
“Bond and MItchell (2010) show a conspicuous lack of alpha, on average, for managers in the other major illiquid asset class, real estate.”
The data used in that article is most uncertain for real estate. They impute rents (imagine how different the imputed rental income would be on real estate within different markets in the US today where there is such a wide range of whether it’s economically better to rent or buy) and it doesn’t account for the taxes you pay on owning real estate each year (unlike equities and bonds which only generate taxes when paying dividends/coupons or being sold).
About debt being a tax shield, consider the following, which will depend on the tax laws that apply to you. Often, interest on investment loans is deductible against ordinary income. However, the returns on investments may be taxed at lower rates than ordinary income; this most commonly occurs with dividends and capital gains. And the returns on capital gains can be deferred. This can result in what is called the tax arbitrage of leverage. I’ve seen one analysis, where the breakeven point for using debt was about 2/3 of the interest rate required to service the debt. Obviously, your situation may vary considerably from this.
In some situations, leverage can decrease risk. When you invest, you face the sequence of returns risk. If you set aside money every year for 30 years in preparation for retirement, the resultant portfolio size will be much more effected by return in the last 10 years than the first 10 years. Poor returns in those last 10 years could be devastating. If you lever your initial investment at the start of the 30 year period, you will decrease the sequence of returns risk. That’s the basis of the book “Lifecycle Investing”. Please remember, I’m not recommending the strategy advocated in the book. Only a seasoned investor should use leverage, and the amount of leverage discussed by WCI is reasonable.
As discussed previously, when it comes to inflation, you want assets that will do more than hedge inflation. You want assets that will profit from inflation. Fixed rate loans or tax deductible floating rate loans have the potential to profit from inflation. Both can profit from unexpected inflation, and tax deductible loans might even profit from expected inflation. I can’t think of another way for an individual investor to profit from inflation. Of course, such loans will expose you to the risk of deflation. But with fiat currencies, inflation risk is greater than deflation risk. To have a small portion of your portfolio (15%?) allocated to assets which can profit from inflation is a strategy to consider.
If you do use leverage, that leaves the question of how much to invest in fixed income. To use leverage and also own fixed income assets is like having your foot on the brake and accelerator at the same time. The reasons to own fixed income are to match assets to liabliities (hedging), decrease portfolio volatility and provide steady income. Leverage will increase volatility and requires a steady income to service the debt. IMO, if you’re using leverage, you should only use fixed income to asset liability match. If you need fixed income to decrease volatility or generate steady income, then you probably shouldn’t be using leverage.
“I almost never run into docs whose debt ratio is between those numbers. Usually, it is dramatically higher.”
About how much debt people take on or don’t take on, your point is well taken. When it comes to debt, my guess is that there is somewhat of a binary distribution in the population. There are those who take on more debt than the should, especially to consume. And there are those who take on no debt at all.
I consider debt optional, but if you are going to take on debt, the numbers WCI suggests for nonconsumption debt are reasonable. Of course, everyone’s situation is different.
I wonder how this comes into play when you are investing in multifamily properties. Should the first property be paid off prior to acquiring the next one? What is the best way of doing this when you are attempting to purchase one property a year?
Nima, I am debt free in the personal side, but do have investment real estate debt. I bought my real estate as a place to invest my excess money after I became debt free. I have a personal budget, which does not include debt. I also have a real estate business LLC budget that does include debt. I always bought my properties with debt and with a positive cash flow. That way the tenants are paying off the debt and also sending me some spending money as well. In fact I am retired today on the spending money they send me. But I also approached the real estate debt the same way I did the personal debt, pay it off quickly. So when I was still working, all the cash flow my properties made went towards paying off the debt faster since I didn’t need the money to live on yet. Now that I am retired, I use some of that money to live on, but still do make extra payments toward the mortgages. I want the real estate business to become debt free as well.
Dr. Cory S. Fawcett
Financial Success MD
Thank you for your response!
I am doing the same thing, essentially all the net profit is being used to pay off the debt. I am lucky since my practice gives me a 7 figure income so that I can save enough money for the next property pretty easily but I am still a little scary to owe a few million on multiple properties.
Sit back and decide what your goals are and how much leverage risk you need to run to reach them. The only good guidelines I know are to keep leverage to no more than 65-75% of each individual property and no more than than 15-35% of your total assets.
Jim, I love this article! You make a lot of great points that I wish I had include in my book, The Doctors Guide to Eliminating Debt. I too have been on both sides of the fence. I started out my practice years accumulating over $500,000 of debt. My wife did not like that so much and encouraged us to get out of debt. So we did. In 2001 we made our final house payment and have avoided personal debt ever since. I have used debt in my real estate business, but that debt is not requiring me to pay it off. The tenants do all the heavy lifting for that and send me a check to boot. Even that debt is being paid off at any accelerated rate in the desire for my real estate business to become debt free as well. Every time I pay off an investment real estate mortgage, my spendable cash flow goes up. I love it when that happens.
I plan on adding this to next weeks Fawcett’s Favorites.
Dr. Cory S. Fawcett
Financial Success MD
I don’t post much, but maybe I should link to this in every Bogleheads “should I pay off my mortgage thread”…
Great post. Motivation to keep the course in paying down my debts (mortgage/student loans/a 0% loan on a van for the family). Don’t regret these, but life would be simpler without that debt.
Please do, they certainly won’t let me do it!
I feel ya.
Answers to opening 1-2 paragraphs:
Question 1 : 4 M in retirement assets – NOT including house.
Question 2: 15 year mortgage at an initial rate of 2.75 %. We are at ~ year 7 or 8.
No question having such a low rate has helped our Nest Egg grow over the past 7 years.
Not at all inclined to pay it off anytime soon.
So how much of that $4M can be attributed to not paying off the house? Have you run the numbers? I bet you’ll be surprised how small the contribution has been if you do.
With all due respect: my monthly payment of principal and interest is 2225/month or 26.7 K per year. Are you really trying to say that investing that amount of money per year in the market over 15 years is not going to amount to much ? Please go ahead and run the numbers based on an average return of 6% per year. Thanks
By the way, whatever the number is, please don’t dismiss it as not significant. I’ll bet this number will be far more substantial than whatever is saved by seeking out funds that save us 10 or 20 basis points 😜
That’s exactly the point though…we spend too much time focusing on the stuff that doesn’t matter all that much and too little on the stuff that matters a ton (income, savings rate, having a plan, following said plan etc).
I do encourage you to run the numbers though. When I’ve done it, it was much smaller than I had assumed, and that’s assuming I got all the behavior right.
You have to compare apples to apples. I don’t have all your data so I can’t do it for you, but let’s say you have a $500K 3.5% mortgage right now that will be paid off over 15 years. You have $500K right now. If you pay off the mortgage, you can now invest that money that would have gone to the monthly mortgage payment. If you don’t pay off the mortgage, you can invest that $500K. What does the difference end up being? Either way, after 15 years the mortgage is gone and you have some lump sum of investment. If you pay off the mortgage, you invest $43,412 per year. If you don’t pay it off, you invest $500K once. Let’s say you make 8% on your investment.
=FV(8%,15,-43412,0) = $1,179,000
=FV(8%,15,0,-500000) = $1,586,000
Difference is $407,000.
Now adjust for taxes.
Now adjust for risk.
Maybe you’re now down to a $100-200K difference.
Meanwhile, your net worth is now $8 Million (or whatever).
$200K of $8 Million is just 2.5% more money. It doesn’t move the needle. It made no significant difference in you reaching your financial goals. But perhaps it kept you from making certain career or personal decisions along the way that would have made you happier.
At any rate, once you know the numbers, you can decide whether it is worth the leverage risk to you in your situation or not. I met a doc this weekend for whom it absolutely was worth it because he detests his work and is locked into a HCOLA by family obligations. He’s willing to take A LOT of risk to try to earn a higher return. But for most docs, it’s kind of a “meh” moment.
Great example. But it illustrates how keeping the mortgage can be the better move, depending on the interest rate and the expected returns for an alternative investment.
The tax adjustment can add a good amount to the balance from keeping the mortgage.
Difficult to know how to adjust for risk. One would have to look not only at the risk in the investment but also the risk of putting more money into the, risky, real estate investment before those investments in the form of principal payments were due.
The conclusion seems to depend on the obvious points-the lower the mortgage rate relative to investments, the stronger the argument for keeping the loan. The bigger the tax advantages, the stronger the argument for keeping the loan.
At a networth of $8M, $200,000 would be a lot of money for me. Certainly worth keeping a mortgage and delaying the satisfaction of being debt free. One would have to ask whether closing out the mortgage, which would cost $200,000 to do, would provide $200,000 worth of happiness.
I would rather have the money.
I would feel the same way if the difference were $20,000. I want the higher NPV deal.
I would feel the same if the difference were $2,000, although at that point I would assume the actual relative value, vs projected, would be lost in the errors in predicting discount rates and investment returns.
If I believed the difference were $2 or $20, I would probably close the mortgage early. At that point, why not?
But throw away $200,000, or anything close to it for an emotional gratification of paying off early? Not something I would do.
That’s why it is important to run the numbers and then make a judgement call. When I was young and poor I would have done a lot for $200K. But at this point I’m not going to arrange my financial life for the next 15 years around getting it.
A lot of people interpreted this post as being “anti-debt”. In reality, it’s a discussion of how to use debt in a smart way. Since most doctors have debt ratios that are way too high, getting them down to a reasonable amount (15-35%) would seem anti-debt, but I’m hardly advocating for everyone to be completely debt free by their early 40s as I am. It works for us, but we’re a pretty unique case.
Not pro or anti debt. Just following the principle of “seek the highest NPV options”.
If one had a sufficiently high aversion to debt and this was incorporated in the NPV calculation, then spending an extra 200k to get out of debt might be reasonable. One would have to model it as a utility of cash flow worth at least $200k to make it work out.
For me, paying off a mortgage early has no value in itself. So I would assign it a worth of zero dollars. That would leave the payoff early option under water by $200,000 and I would not do it.
If someone had an extreme fear of debt, then maybe it would be worth paying $200k to get out.
Not for me. Just NPV it and go with the higher option.
To assign it zero value at all reflects ignorance of the risks of leverage/deflation/depression not some “ironclad stomach that can withstand anything”. Even if you don’t put much value on it, it would be foolish to say it has no value at all. That’s just silly.
Overall agree with the many great points made here. I don t post much but felt to add some balance to the discussion that the decision to pay off a mortgage or not can be complex. Some of the key points of this complexity I did not see here. First, many people look to pay off their mortgage to live for “free” in their home but the HOA taxes and insurance costs (which for me in Florida are over a 1/3 and almost half of my total payment) are not going anywhere so there will still be regular home related bills to pay even with the mortgage gone. Also, the issue of present value of money versus inflation is a factor. My mortgage payment will not change even though the buying power of the money I spend on it will continue to steadily decline as time goes on so the real value of the money you spend on it decreases. This is a key point often not considered in this analysis. The peace of mind of paying it off is undeniable and it many cases alone makes it worth it but but from a purely financial analytic approach, it is a complex decision.
We are not paying our off for now as I truly am investing the full difference I would use to pay it off and I also do not believe will be in our current home for life and therefore I prefer to have flexibility with our funds.
Thanks to the WCI for all he and his team do for us!
Lots of math arguments there, but no behavioral ones. What percentage of personal finance success do you attribute to math versus behavior?
The key to success in investing /personal finance in my opinion is having a good plan and sticking to it. No reason you cannot have the math on your side also. They are not mutually exclusive.
Agreed.
When the mortgage perhaps should not be paid off? Having lost money on both of the houses we had owned previous to this one, we considered the possibility that having a paid-off mortgage and a realtor feeling that we don’t need to get any set number out of selling the house would decrease the eventual selling price. I also wanted to retain the less-than-honorable option of telling the bank you keep it, we have enough cash to buy our next house so we don’t care if we get a bad credit rating, if the likely sale value of the house ended up being such a huge loss over our purchase price that I wanted the bank to share some of the pain.
Does having a mortgage when you get another house make it tougher or not to get the next house? A bigger down payment because you haven’t paid off the mortgage might make it easier then the ability to get a mortgage especially if you’re moving without a guaranteed income etc. Such as in retirement or setting up a new business though usually doctors can get credit in those situations.
Could make it harder (worse debt to income ratio) or easier (better credit score, more credit history etc)
I don’t think “retaining the option to send in jingle mail” is much of an argument on this topic though.
I love the premise of this article, Jim. I especially appreciate you first point on justification. I see too many people who justify not paying off for the exact reason you outline.
However, I also see a lot of people who want to get out of debt, only so they can eliminate payments and free up cash flow so they can spend more. For example, I’ve seen people sell a house to pay off student loans, only to have to pay rent for several years and then when they went to buy another house, prices had gone up dramatically.
They ended up worse off because they were so hyper-focuses on paying off debt.
Again, to me it is all about living within one’s means. Moving money from one bucket to another bucket (whether it’s from an asset to pay off debt, or avoiding paying off debt to invest more) doesn’t really move the needle that much.
Spending less so you can pay off debt and/or invest more is what really makes the difference in the long run.
Good counterpoint.
Absolute gem of a post Jim.
I had a post about becoming debt free and I had discussions from so many saying that I could have made a lot more in the stock market if I didn’t pay off my last debt (mortgage). It’s been over 4 years of being debt free and I would never go back even if I could earn a little more because of leverage.
It’s a huge weight off my shoulder when I paid off my mortgage. And for me it really felt amazing when I knew my property and every blade of grass on it was owned by me and not the bank.
It would be interesting to see what those people say when a recession hits and they would have been better paying off a debt and getting a return instead of a loss.
The only argument that holds water for me against paying off a mortgage is that you are paying it off with today’s dollars which sre going to be more valuable than the dollars you would have paid a few decades from now. Even then I still would do what I did every time.