Today we're going to talk about the best ways to use debt (leverage) to your advantage. The original title to this post was How Much Leverage Risk Should You Take, but alas, this one is more clickbaity and does better with the search engines, so I was overruled. We actually ran a post from Passive Income MD a couple of days ago that discussed using leverage in a rental property portfolio, but this post will focus more broadly on debt.
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.
Is Your Debt a Disease or 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
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.
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!