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!
I am a long-time lurker and first time commenter, but what finally caused me to comment here was the link to the 2008 Market Timer thread, which I had never seen before. Power-skimmed through it today. Even if I had never gained any financial wisdom from your website (which is far from the truth), you would have my gratitude for introducing me to such a quality thread.
Glad you enjoyed it. At least it has a happy ending.
Wow, great post and great comments.
One exception (that makes the rule) I think is being IN retirement. We are 54 years old and just retired after 28 years on Active Duty. Thanks to aggressive savings, I am not planning to work again. Since I was AD, we moved a lot (4 moves in the last 5 years) and thus don’t own our house.
We are still nailing down where we will finally land (Gulf Coast of Florida is looking really good – where my last job was and it is amazing here), but once we do, I don’t plan to pay cash for our house. Any cash I use will come out of our retirement accounts (about 40% of which is in a taxable account), so I really will be trading time in the market for no house payment. Plus a 6 figure retirement check from the government (indexed to inflation) makes for a pretty stable retirement income.
All that said, I do plan to land somewhere in the middle. Trying to talk my wife off the water’s edge (may lose that discussion!) to reduce cost, but we plan to take a 15 year loan with at least 25% down and maybe as much as 35%.
I welcome counter-thoughts, I certainly don’t have all the answers, but I think this is one example of an exception to your very well thought out post. Thanks!
Why would it be an exception? Did you not read to the very end where I discuss how much leverage one can profitably use (15-35% of assets)? I’ll bet a mortgage fits in that formula doesn’t it? Certainly if you assign some value to the pension.
As always, you are so right. I didn’t think of it that way. Love what you do, thanks!
Brilliant post, should be pinned as classic/essential reading on front page of the website forever. This sounds like something Dave Ramsey might say if he had gotten an MD – same underlying philosophy but articulated with logical arguments rather than calling you stupid!
I wanted to say that this was a very well written post Jim. Thank you. This should be handed out to medical students on the first day of school and then again on graduation day.
Bravo Jim, well done!
Awesome post, thank you! What about the argument that inflation works in your favor when carrying a long-term mortgage? We’ve got 19 yrs left on a 3.2% mortgage and we’ve only been whittling away at it lightly, thinking that at an inflation rate of 1.2% (variable, I know, but just for argument’s sake), we’re only really paying down a 2% loan over time? Since the amount borrowed in 2018 will be worth less when ultimately paid off with 2037 dollars? Just wondering your thoughts on that line of reasoning. Ultimately I agree that with the right money mindset, habit, and behaviors, it shouldn’t move the needle much whether you pay off the debt or invest as long as you live below your means and use the $ difference wisely.
Yes, you should always think in terms of after-tax, after-inflation money. Certainly fixed debt does well in times of high inflation, just as nominal bonds do poorly.
Great blog post (as usual), Dr. Dahle.
One counterpoint that I hope everyone will consider is that having excess cash is a debt prevention mechanism, and debt prevention vs. debt reduction should be carefully evaluated. An appropriately-sized emergency fund is an extremely important debt prevention vehicle and just about everyone should have one (about the only exception, for those in the accumulation phase of their lives, would be in the case of someone who already has a large taxable brokerage account as part of their retirement nest egg, which can serve as an emergency fund). If you are temporarily out of a job or if your income is greatly reduced for a period of time (as many physicians experienced in 2020 due to the pandemic) you will be very glad you kept that emergency fund instead of paying off a 3%-4% debt (credit card debt, which would very likely be amassed if you need cash and don’t have an emergency fund, is extremely expensive debt).
Additionally, having “squirrel savings” funds to pay for known future needs will help keep you out of debt. If your home needs a new roof or AC unit, or your car breaks down and you have to make a decision between a $10,000 repair bill or a new car (something I faced myself in May/June), having cash on hand to pay for the new roof/AC unit or to buy a new car will prevent you from adding debt unnecessarily. While that debt may not come with a high interest rate (car loans are cheap…for right now), it could easily be a 4% interest rate debt or more, and if you save cash preemptively for those needs it earns you interest until you need it (a key part of the math in making the right decision).
This is really all about find a balance between peace of mind (getting out of debt, and staying out of it) and doing the financially smart thing (comparing after-tax returns on investments over time vs. the after-tax return of paying off debt) with each incremental dollar. To oversimplify this a bit, deciding between debt reduction and debt prevention can be boiled down to evaluating the interest rate on the debt you are paying off vs. the potential interest rate on the debt you are avoiding in the future if you have saved cash for a known future need PLUS the interest you earn on your cash while it sits in a high-yield savings account until it is needed. The decision between debt reduction and retirement savings is a bit more complex, and it is a very personal decision. Peace of mind matters a lot. If a 3%-4% debt feels awful to you, and you want it gone, use that incremental dollar to slay the debt. You likely will earn a better after-tax return in a taxable brokerage account if you invest that dollar in an appropriate mix of stock and bond index funds than you will by paying off a 3%-4% debt, but the difference in the size of your retirement nest egg when you retire likely won’t be significant.
I agree there is little sense in paying down debt if you are about to take it back out.
Without disagreeing in the slightest with the overall sentiment, how many of the people commenting here – including WCI – borrowed money for their education? To buy their home? To buy their practice? I feel pretty confident the number is going to be 100% minus a handful of folks in truly exceptional circumstances. Turning around and saying “debt is bad” isn’t helpful because that’s exactly what you all used to reach FI and/or achieve a significant net worth.
Perhaps a better way of thinking about debt is based on where you are on the personal finance path. Starting out, it’s almost guaranteed you will go into debt. Significant debt. That’s simply a practical decision regardless of whether you think becoming a debtor is good, bad or meaningless. The 25YO can’t adopt the same financial mindset as the the 65YO multi-millionaire or they’re unlikely to become that person later in life. It seems more sensible to recognize there’s a transition point where being completely consumer debt-free has more benefits than earlier in life vs. arguing about a universal principle that should be followed at all times.
However, I haven’t the slightest idea how to calculate that transition point. 😉 Maybe it’s immediately after you’ve achieved a positive net worth by both aggressively paying off the loans and saving/investing. Maybe it’s only when there’s positive cashflow from other people being used to make the payments. Maybe it’s when you turn fifty. Maybe it’s after you retire. Dunno.
At this stage in my life, that means being personally debt free but still quite willing to borrow money for purchasing cashflow generating assets. Although I’m pretty aggressive about paying off business debt to minimize risk, it’s unlikely that I’d pay cash for a rental property or a business. The problem is when people confuse that type of leverage with the seemingly equivalent “Keep the 3% mortgage and invest the difference” which definitely stops being useful at some point down the road.
How about a counter post titled “When Does It Makes Sense to Borrow Money?”
I thought that was the post I just wrote. Did you read all the way to the end? You seem to be misinterpreting this post as an anti-debt post rather than a how to use debt, how much debt is reasonable, how you should think about debt etc post which was the intent.
Behavioral:
I suppose there are some for whom getting out of debt satisfies their emotional needs. They pay off the loan, even if pure financial arguments say to keep it.
There are others for whom getting the highest NPV out of the mortgage and investment universe produces more emotional gratification than would getting out of debt. They keep the mortgage and invest the principal they would have paid back early.
With the low interest rates lately, many people have after tax mortgage rates below 2%. It is not too optimistic to project an after tax return on investments higher than that. As long as they can afford the mortgage in the first place, this can be the best decision.
If one would use a mortgage to buy an investment property, then why not the same thing for one’s home?
It is an asset. It is possible to get very low rates on loans for the primary residence, lower than for investment properties.
For years I struggled with this decision. Should the extra cash each month go to investments or debt pay down? In my younger years I decided to split the difference by doing some of each because the debt pay down was a guaranteed return, and the investments were a higher return but far riskier. Eventually the home mortgage got paid off and the free cash flow grew.
We also have a lot of real estate investment property, and after finishing off the home mortgage, we paid off all of our investment property debt. And now the free cash flow is truly overwhelming. Despite our ever growing charitable contributions, we pay a 7 figure income tax bill each year. We live on only 10% of our income despite a lavish lifestyle. Flying first and business class is enough for us. I have no real desire to fly on a private jet.
I am currently thinking through the decision about continuing to grow our wealth, vs. just leaving well enough alone. I am tempted to continue optimizing as I have always done. It is pretty much a habit at this point. That would mean investments that would generate large tax deductions and lead to further growth of wealth, but there comes a point where enough is enough. Old habits die hard.
Congrats on your success. Why not focus on optimizing your time instead of your money?
Ziggy, indeed congrats.
If you are open to sharing, I’d love to know how much debt you had to take on in order to establish such a successful real estate empire. Was there ever a time when your debt was greater than the 15-35% of assets that is suggested here? Or what ratio was your debt would you say at its peak? Do you think 35% is too restrictive for real estate empire building?
and ps. do you have a medical background also? (student loans?)
Loved this article as I have been having frequent conversations with my good friend (who happens to be a very wealthy lender) about paying off my mortgage faster than planned. I understand both sides of the argument and this really put things into better perspective for me. I am hungry to be debt free and my mortgage is the only thing hanging over my head. Can I get some weigh ins from the savvy readers and WCI?
Age: 43
Net worth: ~1.3 mil (Maxing out 401K, defined benefits, HSA, Roth, +50K annual into taxable)
Savings rate: 40%
Home value: ~1 mil (not included in NW)
Mortage: 15 year fixed at 3%, 333K left in loan, maturity date 06/31, currently paying biweekly, and set to be done 03/30, age 53
Goal: Be debt free by 50 (clearly I’ve got to throw more at the loan if I want that to happen). To be exact, I’ve got to throw an extra 10K per year at my loan to pay it off just before I turn 50. That 10K has to come from somewhere so prob means reducing my taxable investments to 40K/year.
Is this worth it? Emotionally I say yes. But if I apply the FV equation from most recent post (assuming a 5% return on $10,000 invested over 7 years):
(5%, 7, -10000, 0, 1) = ~85K
I get it. Don’t sweat the small stuff. Maybe 85K isn’t that much over the life span but as I’m still striving towards FI it sounds like a pretty nice chunk of change.
Also, could do a refi to a 10 year fixed at 2.375% (min costs through my lender friend). After crunching LOTS of numbers it would save me about 6K over the life of the loan whether I pay it down faster or continue on current trajectory. Is there a reason I shouldn’t refi if I plan to pay it down faster? Lender friend doesn’t think it’s worth it for that amount of money, but to me 6K in the pocket is a win. What am I missing?
Why would you include the mortgage but not the asset? Kind of odd. I’d stop doing that to start with.
You didn’t mention your income, but I assume it’s high because you’re here and maxing out a bunch of accounts. I think it’s great to take $10K of that $50K you’re putting into taxable and use it to pay off your loan.
If the $6K is worth it to you, then go for it. But honestly, I bet you pay this debt off by 46, not 50!
My vote is to split your taxable contributions in half and put that towards your mortgage. That way, you get the win-win of feeling accomplished by paying off the debt, and also the assurance of getting a higher return investing.
Also, I would refinance as well. I mean, there’s really not much of a downside if the expense is minimal… and gathering up financial doesn’t take much time. I’d do it for 6k… or even half that.
Careful about paying your mortgage biweekly as this does not decrease the amount of interest you pay,. Far better to pay extra monthly to principal, rather than pre-paying the full amount, which is what you’re doing by paying twice a month.
Truth, all of it. Because behavior trumps math, most of the time. I’ve been thinking about this since yesterday… with all the restlessness in medicine today- this message may be getting buried. I worry that many young docs, who still have sizable debt, may be getting the idea that doing things to “create wealth and other streams of income” is the ticket out. It may be, but hopefully they’re also paying attention to debt and working to get that out of the way, too.
What really hit home for me in this post was the point WCI made on “It’s easy to do so because mathematically it is correct. …. because the argument is so darn common, even among people who are debt-free!” Even though I am striving to be debt-free (My mortgage is my debt at this point) I do find myself debating the point of not paying off your mortgage as fast as possible. And it stems from many of the WCI points and just the old belief that mortgage debt is “good debt”.
Ironically I am a big believer in the ‘Rich Dad, Poor Dad’ mentality of not including a house in the Asset side of your balance sheet until paid off. That little “definition of terms” has helped me make wise decisions in the size of my mortgage and purchasing other property. I count my net worth without the House Equity (and cars) but for fun and pride I do keep track of the traditional networth formula from time to time.
I’d include the house as an asset but I’d also include the mortgage as a liability. Otherwise, you’re heavily incentivized to sell and rent.
https://www.whitecoatinvestor.com/a-home-is-an-investment/
Looks like I am slow on the draw with 78 comments already. Maybe I am one of the unicorns that is benefiting from not paying off low interest debt. I think your question about “did the debt make you rich” isn’t really the right question. Would I be rich without having debt? Sure. This blog is about making good financial choices. The right question is does maintaining low interest debt make you wealthier or more successful at achieving your financial goals than if you didn’t. At the end of med school it became clear to me interest rates would be historically low. Until that time we used my wife’s income and living very simply to minimize med school loans as much as possible. We made a choice to max out loans the last two years for school and invested my wife’s income instead. Of note we did not invest the loan money itself but did invest the money my wife was earning that we had put toward tuition and living. Loans are locked at 1.6%. In 2001 I had $106,000 of med school loans. Today its still $86,000. I could pay that off with one month of my current salary. But why? I put all the money I am not spending or giving away into the market. That 106k we invested in 2001 is worth way more than that now.
Similar with home mortgage. Why pay off a mortgage at 2.25% fixed for 15 years when the interest is 100% tax deductible? That brings the essential interest down to about the same as my student loan. Sure there isn’t a MMS at that rate now but trusting long term in market returns its foolish to pay it off early.
In answer to your questions
1) are you rich yet? Yes. I buy whatever I want and save about 400k a year and give away almost as much.
2) DId you do it carrying 2-4% debt? Well technically 1.6%. Could have and could now do it without that but no question it helped to get several more years of market returns in Roth IRAs and overall market.
I wanted to go point by point through your 14 reasons since I think there is a good counterargument to each but this comment is already too long for anyone to read.
Why? Because it isn’t making a meaningful difference in your financial life. I mean, you make $100K a month. Leveraging up a couple of months worth of earnings is a rounding error in your life now. You’re not rich because you did this. You’re rich because you made a lot, saved a lot, and invested it in some reasonable way. It’s the whole “optimizer vs satisficer” thing.
You do all kinds of financial things that “don’t make a meaningful difference in your financial life”. If you think that way about every decision added together it moves the needle a bit. Could you have been financially independent without doing Backdoor Roth’s? Sure. So why bother? Because it’s smart investing. Could I pay off my student loan debt this month? Sure. But why? It’s on auto debit so I rarely think about it. I have better uses for that money. Some months I give it to my church. Some months I add it to my index funds. There’s always something more useful than paying it off. Just because it’s not a huge number doesn’t mean it’s not important.
Also that decision to come out of med school with close to six figures in Roth IRAs and other investments made things a lot more comfortable the first 15 years after med school. Those are real dollars and the debt has never affected me since I paid zero in residency or fellowship and a few hundred after. So did it make me rich? I think that’s the wrong question. I didn’t know I’d make 7 figures some day and that wasn’t really my goal. So the question is was it wise. I’d say yes. It’s essentially free money. Is it wise still to use the money for something else? Yes.
It’s a good argument.
Only home mortgage interest Plus 10K property tax above $24,800 is truly deductible. Depends how much over you are to determine your true effective rate.
While my crystal ball is as hazy as every one else’s, my suspicion is that the government spending of trillions of extra dollars will become a routine, yearly feature, not an aberration. I find it hard to imagine a world of such astronomical government spending where inflation will remain in it’s current low level. Annual inflation of 5% or even 10% a year could be just a few years away. I just refinanced to a 2.5% 15 year fixed mortgage. The looming inflation is my biggest motivator for not paying off this mortgage early.
A reasonable argument but you have to have enough debt to move the needle.
I have to say Jim that I am stoked after reading this!!! I am in the camp of optimizing- instead of paying off debt I invest, but you definitely make great points, especially #1. I have justified to myself into thinking that inflation is eating away at debt and that any money I have left over I will invest. But inflation is super low right now and that money I would have used to pay down debt is sitting in a savings account so we can buy a pool!
I have modified my student loan debt part of my financial plan as follows, changes in quotes:
1. We will do minimum payments to our 1st Republic loans given it’s a 1.95% 5 year fixed. We will invest the rest of the money and make sure money we would have used to pay down the loan is not just spent, “unless I read a WCI post and get stoked to pay more of this off.” We will pay off the loan in full by 5/8/23, which will be about $27K according to the amortization schedule, given we will get about $2K credit for paying off the loan one year early.
2. We will make minimum payments on Navient loans given low 2.6% fixed rate, and instead invest the rest of the money, “again unless I read a WCI post and get stoked to pay more of this off.”
going to the Navient site right now, taking out of the pool fund . . . don’t tell my wife . . .
“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.”
I read a little and skimmed a lot, but got to the end. Quite a tale. I enjoyed MT’s commitment to finishing the thread. 13 year thread. Glad he came out of it well.
Great advice and thread above.
Jim,
I loved the post and was agreeing with every point until I though back to where I was 11 years ago. If I had read this post then and followed your advice I would definitely not be as financially secure at this stage. Since I was reading your posts from the early days lucky for me that was not your view back then.
Here is our debt story:
Our first debt was a 5% mortgage of $400,000 with $115k down on our condo in 2009. Able to refinance down to 3.875% (30Y) in 2012. In 2014 we took on another mortgage of $775k at 4% on home in suburbia and just refinanced down to 2.625% 30 year (yesterday) and turned condo into rental property when we moved to the burbs.
Based on our incomes in the early days all my moonlighting went towards a SEP which I converted to Roth, maxed out our two 403b’s and maxed out two back door Roths and 1 529 plan until it reached contribution limit a couple years ago. Oldest of 3 still has 7 years till college and 529 should cover all three kids. As our incomes grew we opened two 457 plans and maxed them out.
Condo rental has delivered a steady positive cash flow of $14k per year but small declining loss for tax purposes. 2020 may be the first profitable year. We took on another 205K at 3.25% (15 y) in debt in 2019 for a summer vacation house that we rented this summer with expectation for negative cash flow and a loss to offset future condo earnings in exchange for two weeks of vacation and free working long weekends (Less than 14 personal days per year!). But to my surprise Covid resulted in a high demand for Cape rentals and house generated 33K in rental income this summer and a positive cash flow, Crazy! I considered this house a want and not an investment. In the end it might actually turn out to provide a decent return. As I was writing this I just got another off season rental request.
If I can just figure out a way to make a boat profitable I might buy a used one. One idea was to have my kid use it for a summer job delivering ice cream and iced coffees to the beach. Still working on that one.
So in the end with a total of 1.380 million of financed debt our portfolio grew from around $300k in assets when we got married to 5.6 million between 2009-2020. Our income started around 300k and grew to around 525k. So the majority of our wealth was generated by investment returns and equity in our properties. Our annual return from our investment accounts has been 10% over that time period. We did luck out with the timing of the longest bull market in history and purchasing our first property at the best possible time. But after taxes we leverage our debt by at least 7.0% (didn’t do the exact math).
If we had focused on paying down our debt early on instead of building a real estate portfolio we would not be in the same position we are currently in. I have mentioned in the past that my fellowship program director told me renting out my condo was the stupidest thing I could do. Lucky for me I didn’t listen to her and listened to the numbers which at the time suggested a slight positive cash flow.
Now the reason I was initially agreeing with every point as I read your post. Like you, I am in a different place now. We are now starting to have more cash savings with an emergency fund that is way too large. So I am now entering the pay down debt phase. My original plan was to start building an income portfolio with high dividend stocks but really at this point there is no need to take on further equity risk so I plan to start paying off our debt which in total is currently 1.2 million $690 from our primary residence at 2.625% we still are above standard deduction by about 6k. Condo has 313k at 3.875% and summer house 198k at 3.25%. We are currently 21.4% debt to equity ratio. Goal is to pay off condo in next couple of years since we still fall into itemized deduction for our primary residence and will for at least another 5 years. And in 5 years if bond rates are the same I will pay off the primary mortgage. If we see a repeat of 1981 bond market I won’t.
The low cost debt that was available to us has definitely allowed me to build significant wealth. Between 2009-2014 100% of every extra dollar we earned was used to max out our investments and were 100% equities. Between 2014-present we reduced our equity position gradually.
All our ducks lined up, would that work again in today’s environment. I would GUESS no but who knows maybe another 2008-9 crash is just around the corner and one of the medical students/residents reading this will have a similar opportunity?
Good luck and use your debt wisely!
Glad it worked out well for you.
Follow up question. I re-read your post and guess I would be that rare Yes/Yes to your two questions.
Question: what loan do I pay off first? Will most likely be in 35% federal and 5% state brackets.
Condo rental 313K left at 3.875% interest will always be fully deductible so effective rate 2.325%?
Primary residence: After refinance from 4% to current 2.625% 30 year with 690K left. Effective rate isn’t really 1.57% but not sure how to calculate what it actually is. Only $3,300 net above Standard deduction, so only about 18% of excess interest is deductible so I estimate effective tax rate is actually 2.43%, is that correct?
So technically the primary residence should be first? Just feels wrong.
Consider your condo an investment or business expense, and your home a private expense. Then just decide whether you would pay off your mortgage or not? and whether you want to continue owning the condo as an investment. Financially of course it makes sense to pay off your mortgage unless you decide you actually disagree with the article re using loans to further invest. Further disaster consideration: if you lost $700,000, would you prefer to still own the condo or to still own the home?
Condo and vacation house mortgages are both considered business expense.
I am now in a place where paying down debt to reduce liabilities is preferred over taking on extra risk.
Question was which loan to pay off first, condo or home? Vacation house at an effective rate of 1.95 will be last. Condo interest (Rate 3.875%) will always be deductible. But in five years we will be in standard deduction range for our home loan unless we start donating more or tax laws change.
By the Math seems like house should be first by 0.1% (not much of a difference) but since condo balance is much lower we could most likely pay it off in the next couple of years which would reduce liabilities and increase our cash flow. So I am going to do condo first.
They’re only business expenses if they are rented out enough to qualify (15+ days a year).
If the difference is only 0.1%, then I’d pay off your residence.
Great, well thought out, and timely post. Emotion trumps math the vast majority of the time and saying that you “invest the difference” is like saying “this time is different”. We have a hard time actually doing what we know to be mathematically correct in the “heat of the battle” known as life.
Curious on what you know about the percentages of docs at progressive ages that live in a “paid off” home and how that correlates to nest egg & net worth.
Medscape has a survey with that question. I think about 1/3 of docs don’t have a mortgage as I recall. Here it is: 37%.
https://www.medscape.com/slideshow/2020-compensation-debt-worth-6012988#7
Nice article. But if you ask someone with $4-6 million:
1. Are you rich yet
2. Did the backdoor Roth IRA or HSA significantly contribute to this
You could easily argue that the tax advantages of backdoor Roth/ HSA are minuscule compared to their net worth. Does this make it not worth doing? Absolutely not.
And for travel hacks and credit cards before covid I was getting $20,000 in free travel (family and parents count) per year. $100,000 over last five or six years will be $800,000 in 25 years. Is this still worth my time?
I still get bank account bonuses and $500 for $3000 credit card spend.
Although I don’t agree with the logic of the argument I DO agree that the mindset of not having debt (or the mindset of travel hacks/ bank bonuses which I refer to “coupon clipping for multimillionaires) adds to net worth. At the end of the day to each their own!
Thanks for a great post Dr. Dahle. So a quick clarifying question for younger docs with less net wealth: should I not get into a primary house mortgage that is less than two times annual household income if the total mortgage puts debt:net worth ratio more than 35%? This assumes no other debt(student loans paid off). If so, this post might help those <5 years out of residency hold off on that house as you often advise. Thanks!
Sure. The point of the ratio is not to have it the day you walk out of medical school, but if you choose not to pay off all your debt in order to take on leverage risk to come out ahead in the long run, you should at least pay it down to that ratio.
I’m fine with people buying houses as soon as their professional and personal life is stable, even with a doctor mortgage. Maybe not the big huge doctor house yet, but if you want to own 6 months out of residency, knock yourself out.
Excellent article. Having read all the comments I think a few things are getting lost.
1. The people saying “hey, but this worked for me” are the disciplined <1% of people who are actually investing the difference.
2. Didn't read the end of the article providing the counter argument.
3. Are still not comparing apples to apples. A guaranteed after tax return is not even in the same realm as possible future stock market returns. (Would you take out a second mortgage now to invest in a bull market that has run 12 years?)
4. Are assuming that they would have not invested in anything else if they had paid the mortgage off early. I guarantee anyone disciplined enough to pay their mortgage off early is going to invest the extra cash after it is paid off.
I am about to buy into the real estate of my dental practice… but my total debt (mortgage, dental practice purchase, office real estate) will reach around 45% of assets. Should I reconsider?
No, but I wouldn’t necessarily run out and buy a Tesla on credit next week or buy an investment property with just 20% down next month or something like that.
Where does real estate investing fit into this? If I have a mortgage on my residence, should I direct all my “taxable” money to paying off the mortgage before considering getting a mortgage to finance a rental property? Should I only buy a rental property if I can pay for it in cash?
I think it’s reasonable to leverage an investment property so long as it has positive cash flow and your overall debt to asset ratio is in the 15-35% range. But if you have $500K in student loans, $500K in a practice loan, $500K in a mortgage on your resident, and only 5 figures in investments, I wouldn’t recommend going out and buying 5 rental properties with only 10% down. Be smart in how you use leverage and don’t overleverage.