Today we're going to talk about the best ways to use debt (leverage) to your advantage. Katie and I don't actually borrow money anymore. My “student loans” (primarily time owed to the military) were paid off four years out of residency in 2010 and then we had some mortgage debt until 2017, a little under 11 years out of residency. We were debt-free less than seven years after moving into our “doctor house.” We enjoy being debt-free for the improved security, improved cash flow, emotional wellbeing, and frankly, the status symbol, pretty much in that order. That said, we DIDN'T pay off our mortgage at the first available opportunity. For a couple of years, we took advantage of low-interest rate debt in order to invest. There were a few other times in our financial life when we used debt as a means for growth.
Are You Leveraging Your Debt as a Tool for Growth?
The vast majority of docs suffer from excessive comfort with debt. However, there are also people on the opposite end of the spectrum, that are missing out on an employer match or the significant long-term tax and asset protection benefits of retirement accounts in order to pay off very low-interest rate debt. Those folks are likely making a mistake. Most of my readers, however, are somewhere in the middle, struggling with the invest in a taxable account vs pay down debt question. That's actually the question I see most often in my work–a young doc has figured out how to live on significantly less than she makes and wants to know what to do with the capital generated by doing so. As such, I've tried a few times over the years to provide some sort of a priority list or some rules of thumb. It usually looks something like this:
- Get any available employer match
- Pay off high-interest rate (8%+) debt
- Max out available retirement accounts
- Invest in assets with high expected returns
- Pay off moderate interest rate (4-7%) debt
- Invest in assets with moderate expected returns
- Pay off low interest rate (1-3%) debt
- Invest in assets with low expected returns
Today we're going to hang out around the bottom of that list. As you'll recall, we had a 2.75% interest rate mortgage (1.6% after tax) we paid off early instead of investing in a taxable account. One of the reasons we did so was to reduce leverage risk in our lives. We no longer had any need to run leverage risk and since it seemed wise to quit playing after we had won the game, we did. However, there are doctors out there who can benefit from leverage risk and today we're going to discuss that a bit.
Using Debt to Your Advantage in Real Estate Investing
Consider an investment property. These can be leveraged from 100% (nothing down) to 0%, however, an investor will typically find that she must have a loan to value (LTV) ratio of at least something like 67-75% in order for it to provide positive cash flow. She can get that either by putting money down, by increasing the value of the property in some way or by buying the property for far less than it was worth. It all gets you to the same LTV. If your LTV is 66% and your property appreciates by 5%, the fact that it is leveraged 3:1 means that your money just went up by 15%.
Of course, you have to subtract out the cost of the leverage, but at any reasonable cost of borrowing, you're going to come out ahead in that sort of scenario. Of course, leverage works both ways. If the value of the property drops by 33%, your equity is completely wiped out. The careful investor uses leverage to juice returns but avoids getting greedy. I've never met someone who went bankrupt while being debt-free.
Using Leverage in Your Life
This same principle can be applied in the rest of your financial life. Even stocks can be leveraged. Sometimes it doesn't seem as easy as with real estate because you can only get a LTV of 50% on margin loans, they tend to always be at variable interest rates, and the loans are callable. But it doesn't take much creativity to realize you can borrow against something besides the stocks in order to get better terms. Just like you can borrow against a property to invest in property, you can borrow against a property to invest in stocks. Voila–long-term fixed, non-callable debt at low interest rates.
There are lots of risks that an investor takes. These include interest rate/term risk, default risk, equity risk, and manager risk. We often discuss risk in terms of shallow risk (volatility) and deep risk (inflation, deflation, devastation, and confiscation.) In many respects, leverage risk is just another one of those risks. For some people, the risk of leverage is less than the risk of running out of money in retirement or not reaching your financial goals in the first place. Those folks ought to consider running some leverage risk.
When to Take Advantage of Leverage
Leveraging up your life is like rappelling on a skinnier rope. It's a lot easier to carry, but if you over do it, disaster results.
So who might benefit the most by taking advantage of debt? Well, it's going to be somebody with low interest, non-callable debt, and low net worth. That probably means an early career doc with either a mortgage or some student loans that have been refinanced to a low rate. Of course, some debt proponents argue that everyone should run leverage risk. Those who have really thought it through don't usually advocate for a ratio any higher than a debt to asset ratio of 15-35% for anyone in mid-career or later. I think a high-income professional in early career, however, could benefit from a far higher ratio of debt to assets. (This all assumes, of course, that the difference is invested, which isn't the case for most people without a deliberate, written financial plan.)
Scenario #1 Reasonable Leverage Risk
A doctor making $300K is one year out of residency, owes $300K in student loans at 4% and $500K in mortgage debt at 4.5% on a $550K house. She has $30K saved for retirement.
That's a ratio of ($300K + $500K)/($30K + $550K) = 138%. But I think few people would argue that this doc is dramatically overleveraged. If her plan is to rid herself of student loans in 4 years and her mortgage in 15 years, I think it is okay for her to invest in stocks or real estate in a taxable account instead of directing additional money at the debt. (It's also okay to direct any additional savings at the debt, of course.) If she needs $3 Million to retire, running some leverage risk in order to get there a little faster seems very reasonable. It is simply a matter of weighing the leverage risk against the other financial risks in her life, both personal (decreased future income, divorce etc) and the shallow and deep risks we all face.
Scenario #2 A Time to Decrease Risk
An attorney in her mid-40s making $150K is a great saver but also scored a sweet inheritance. She's got a $3 Million nest egg and a 4.5%, $300K mortgage on a $500K house. Her ratio of debt to assets is only 9%.
A fan of leverage might argue she is under leveraged. However, I would argue that she has no need whatsoever to run the risk of leverage and should deleverage further by paying off the mortgage with some of the nest egg. It just doesn't move the needle. Let's say she makes 8% on that $300K this year, while paying 4.5% on the debt. 3.5% * $300K = $10,500. $10,500/$3.5M = 0.3%. That $10,500 just isn't going to have any sort of significant effect in her life; it won't move the needle. Decreasing risk and especially improving cash flow (eliminating the mortgage payment from the monthly budget) is likely going to make a far more significant improvement in her financial life.
Leverage Works
I'm not so anti-debt that I don't understand that borrowing at 1% and earning a safe return at 3% or even a non-guaranteed return at 8% is likely going to result in a higher bottom line. But as you move toward mid-career, deleveraging relatively rapidly–at least down to the 15-35% guideline–seems wise. When you win the game, quit playing.
If you want to learn more about leverage and hear some alternative opinions to mine, I recommend a book series called The Value of Debt for a more pro-debt opinion and Dave Ramsey for a more anti-debt opinion.
What do you think? How much leverage are you using in your life? What is your debt to assets ratio and where are you at in your career? Comment below!
I like how you point out a book that is contrary to your opinion. I think that is important to avoid confirmation bias. The thing I like about cognitive psychology is that concepts such as confirmation bias are obvious AFTER they are described but not before. Jeremy Siegel, in his seminal work encapsulated in his book “Stocks for the Long Run,” makes the academic argument that it is reasonable for an investor to borrow money to buy stocks. He believes this is the mathematically correct answer for someone with an aggressive risk tolerance. It can be found in the table on page 34 of the fourth edition of the book. However, there is a fascinating story of some Nobel prize winners that went broke because taking on leverage was the mathematically correct approach. I highly recommend “When Genius Failed” by Roger Lowenstein. It is the story of Long Term Capital Management and how debt can utterly kill you even when it is the mathematically correct answer to use it. In another topic, thanks for the shout out on the financial advisor post. You would be surprised at how little I wind up charging even though the fee is $400. The reason is that it somehow self selects a type of client that is just about done but needs some remaining coaching (in most cases). I make it that much because I don’t want that many customers. That is, I want to keep it a hobby and not a job. That rate seems to be the sweet spot in terms of not getting too much business. It is the exact comment you made when you talk about your speaker fee. High enough to get some business, but not low enough where you get too much business. What is your feeling about risk and rock climbing? I did it once with a med school friend decades ago, and it struck me as risky so I never did it again. Also, did you see that awesome movie (“Free Solo”) about the guy that rock climbs without a rope? What do you think of that? I loved the movie but the guy is nuts.
Yes, rock climbing is risky. But like investing, you can pretty much choose what level of risk you’re comfortable risk. Obviously I’m not comfortable with the amount of risk Alex Honnold takes.
If you like that movie, check out The Dawn Wall on Netflix right now.
Based on the math above, I am at 78% because of our mortgage. I’m (almost) two years out, and I anticipate this leverage dropping dramatically by year five.
I intend to start putting some extra money towards the mortgage in addition to investing more. I want my cake and I want to eat it, too, I guess. I hate debt, but also want to have money invested.
TPP
Great advice here Jim. And as a climber who has way too many ropes I’ll say don’t go below 9.2mm without getting special devices. Things get slippery fast 🙂
I’m very aware of that. Canyoneers use skinny ropes (mostly 8s these days) AND special rappelling devices. An ATC just doesn’t cut it on 8 mm ropes. Ask me how I know….
Oooh, sounds like a great story, especially since you lived to tell it. Do you have rope burn scars to remember it?
No burns, but it was memorable to me. First one down (so no fireman belay), I think it was a double 8 mm line on an ATC (could have been single) with a 300 lb rope in my backpack, ending on a 12 inch by 12 inch ledge with 290 feet of free hanging rappel below. Should have dangled the pack and rigged more friction. Luckily lived to tell the tale. Scary rappel though. Last time I used an ATC canyoneering. I use a CRITR2 now. Much easier to add friction on the fly.
Yikes. Glad you made it outta that!
After some “sporty” rappels myself I always err on the side of adding more friction. I mostly use Petzl Reverso’s to rappel but sometimes still use an old bucket ATC with thicker ropes. Gravity never sleeps 😉
As a real estate investor I’m a big believer in the value of “good debt” (debt that others are paying off for you and puts money in your pocket). Having said that I never have LTV more than 75% and with the appreciated value of our property the true current LTV is more like 50%. I very much like the idea that each month I get tax free equity gain by my tenants paying the principal on the mortgage. Regarding personal debt our primary residence has none. When we bought our lake home we also bought an apartment specifically to use the income from the apartment to pay the lake home mortgage. It has done that for 14 yrs. and instead of using the cash to lower the mortgage and having a bunch of “dead equity” in the lake home, at the end of the process we’ll have both the lake home and the income producing apartment.
Thanks for this! Few years back our casual advisor (my brother) wanted us to refinance the house and buy more stocks for options trading. He was already managing about the house’s worth of stocks for us for that purpose. (Adding our portfolio to his let him play with the bigger kids- qualified investor or something like that). We talked it over and decided we were less interested in the potential gain/ more leery of the potential loss than brother. (The extra 10-15 hours of tax work for diminishing returns as everyone else started options trading may have added to my reluctance.) This article gives me the epiphany that brother and I were in different places as to the benefits of leverage.
More on brother: once he had to borrow $40K because of a margin call. He DID pay it back in 2 weeks, assured me that I’d just saved him having to borrow the money from his 401K type account, and that when a few other margin trades closed he had the money from his stock trading to cover the call. Can’t recall if this was before or after our mortgage refinance decision to prebias or ‘confirm’ our decision on that.
But in addition to the value of one’s investment going to $0 with 66% leverage and 33% loss in value, with 100% loss in value one’s investment has just cost one 200% BEYOND what you’d wished to invest. WAY beyond our/my comfort zone, which brother had addressed by not having us do any options trading of stocks we did not actually own.
Levered options trading sounds like a terrible idea to me.
Had a rental property, it was a good strategy for money, but my wife and i hated being landlords. This was despite having the nicest renters imaginable, who bought the property from us eventually. Here is the thing – i could have taken over my father’s business. Maybe (probably) i was stupid not to, but i honestly do not think i was cut out to be a businessman.
Early 40s, I paid off my mortgage last year and paid off my one rental property that I own, what a great feeling. No leases or anything. Just my monthly disability insurance. I used the first 6-7 years to build my stock equity and then the next 3-4 years to pay off my mortgage. Probably some home renovation now and a new electric car in few years.
“I’ve never met someone who went bankrupt while being debt-free.”
That is a great line. The great pay-off mortgage vs invest debate will always go on but for me I was on the pay off mortgage side even though could have made more money with investing the extra money. Financial peace of mind is more than worth it. There are not too many people who would take a HELOC out on a fully paid off home just to invest in stocks. Once your home is paid off you are more likely to become debt averse and never want to borrow again.
Sometimes I have done the 0% interest for 12 mo on an item I could buy outright, but as you pointed out, it really doesn’t move the needle at all. Still it is nice to game the system to your advantage every now and then.
I am at ~9% and can easily knock off my mortgage which is 2.75% but the few thousand a year I arbitrage is worth it to me while taking me 0 effort as it is auto debited every month from my account.
My wife and I have different views on debt. I think her loans are a pants on fire emergency and she is happy to let them ride for 6 or so more years. Mine will go in about 3yrs with PSLF!
Currently all we have are student loans. But we are looking for a house and so will double our debt soonish.
I’m happy to buy a house, sad to to deeper into debt.
I found this post very interesting, and went back and read the one from 2015 that reviewed the book as well.
I ran my current numbers and they are:
assets – $1.484M
liabilities – $805K
for a ratio of 54%. I have been working hard to pay down the debt and really moving the needle quickly lately. It feels nice and while I don’t agree with Dave Ramsey all the time he provides a strong motivating voice for debt elimination.
I am planning to purchase another rental property this year for $400k.
With 20% down my new numbers would be:
assets – $1.884M
liabilities – $1.125M
for a new ratio of 60%. For such a (to me) big dollar increase in debt I was surprised that the ratio only moved a few percent.
It’s not changing any of my calculus on the rental property but it’s definitely an interesting perspective and I like how fast the math is on the barometer. Thanks for the thought provoking posts. I may pick up The Value of Debt and give it a read.
I am a family doc in mid 30s. Recently spent most of my savings on my divorce. Net worth of about $150k. No loans (though might be buying porsche soon). Living with parents so expenses are less due to that. I am considering taking line of credit from bank at 2.2% interest rate (fixed) which will be tax deductible as I will use taxable account, and use $100k from that LOC to invest in an all in one ETF like ishares AOA and hold it for 10 plus years. So pay < 2% interest (Due to tax deductions) and earn ~ 7% on ETF. Would you recommend it?
I would not recommend a doctor with a $150K net worth buy a Porsche now matter how it is paid for. Nor do I recommend buying cars on credit. I’m not Suze Orman, but if I were and you were calling into her show, the answer would be “Denied!”
Can you address my other question above…. Borrowing with LOC to invest in an ETF (80% stocks and 20% bonds)? Ie using leverage to invest ….
This entire post is about that. If you need leverage to reach your goals, that isn’t a bad way to do it. But it is yet another argument against buying a fancy car.
Correct. It seems lot of people do use leverage but the general consensus is not to use leverage to buy stocks or ETFs given the risks. Also, the amount of profit generated is not substantial either. eg. 100K LOC borrowed from bank at 2.2% interest and used to purchase Ishares AOA ETF that earned me 8% interest, thus net profit of $6500 (accounting for tax deduction since taxable account) per year plus $1000/year of dividends so total $7500/yr (before tax). So we are not talking huge numbers but it’s not minute either. Would you still recommend given these numbers…? Thanks.
If you need to take that risk, then sure. I don’t think most docs need to do that. I never have. Are you in a big rush to get to FI?
Well we all want to get to FI as soon as possible. I am quite behind as my divorce cost me a most of my savings and have to pay hefty child support for 15 more years. So I am trying to accelerate things. I am in canada so income taxes are quite high too. And I plan to borrow bank’s money to invest in a very well globally diversified AOA ETF to reduce the risk, not individual stocks. People use leverage all the time when buying real estate for investment purposes but real estate is way more work than ETFs, so I am trying to make it more passive and use extra time for family, increase work hours etc. I hope my plan isn’t too risky and worth pursuing.
Not necessarily. There are a lot of risks that I was not willing to take to hit FI any faster. Frankly, I hit it at least a decade before I needed to.
At any rate, you very well may want to use leverage in your plan, but that doesn’t mean everyone wants to or should
Hey Jim,
I never comment on websites, but like your site and appreciate what you do so thought I might contribute.
In your second scenario (A Time to Decrease Risk), the individual inherited $3 million. By the 4% rule, she has already reached her retirement goal (4% of $3 million is $127k/yr; her current income is $150k/yr). She has won the game, so anything else is gravy.
One might argue that the $300k is superfluous and is play-money (risk portfolio). She could put it in stocks and, in the long run, make the net 3.5% ($10.5k) per year. Over the course of 20 years (she is 40 years old), that is over $210k (conservatively) with relatively low risk. More to leave for the kids (so they can move out of her basement).
Just perspective from a pro-leverage person.
I’m so honored to get your first comment!