How to Think About Debt
By Dr. James M. Dahle, Emergency Physician, WCI Founder
Debt—there may be no more loaded word in personal finance and its endless debates. It is sometimes (generally inappropriately) equated with slavery. It is also sometimes equated (also inappropriately) with “financial freedom” and “other people's money”. Debt is an important part of our financial system and a useful tool, but it can also serve up financial ruin and it can maintain poverty. In this article, we're going to talk about all things debt. I hope you walk away with a new and more open-minded perspective, some new strategies, and some new respect for the power of debt for good and evil.
Table of Contents
- The Benefits of Debt
- The Dangers of Debt
- Guidelines on Common Debts
- Good Debt and Bad Debt
- Fungibility of Debt
- Alternative Methods of Paying for School
- Debt as a Negative Bond
- Margin Investing
- Pay Down Debt or Invest
- The Benefits of a Debt-Free Life
- The Value of Debt
- Debt as a Tool or a Demon
Debt may get a bad rap in the world's great religious books as well as most of the financial media and blogosphere. The truth is that debt is, in large part, responsible for the wonders of the world around you. Our economy and lifestyles, the best the world has ever known, are in large part fueled by debt. The “consumer culture” is in many ways the strength of America.
For the most part, money is debt. When a government issues currency, it is simply a note backed by the government's ability to tax. However, most money is not created by the government. It is created by banks. We call this “fractional reserve banking”. When you put money in the bank, it might pay you 0.6% on that money. Then it loans it out to others at 6%. That makes sense, right? That difference provides income to the bank that allows it to pay all its expense and to generate a profit. But I've got news for you. It doesn't just loan out your money at 6%. It loans out 10 times your money at 6%. In essence, the bank has created money. But one person's money is simply someone else's debt. It must be. It's the same with any debt. Your treasury bond investment is the government's debt. Your Amazon bond is an Amazon shareholder's debt. Your mortgage is someone else's investment. It's their money.
There are many historical reasons that a historical backwater called Western Europe and its descendants have dominated the world for the last five-plus centuries. Jared Diamond argues the main reasons are Guns, Germs, and Steel. William Bernstein argues that The Birth of Plenty is due to property rights, scientific rationalism, capital markets, and an effective means of transportation and communications. Who knows what factors are most important, but there is no doubt that the banking (debt) systems developed in northern Italy and subsequently improved on in Holland and eventually London and New York had a large part to do with it.
Debt and bankruptcy protections have allowed for the development of the world's largest and most profitable corporations. While they are often derided as persecuting the “little guy”, the truth is that corporations have made us all dramatically wealthier and our lifestyles dramatically better. Guess what? Most corporations used debt to grow to their present sizes and maintain their current business operations. While it varies over time, fewer than 5% of S&P 500 corporations are debt-free.
On a more personal level (which, when multiplied by the billions of people on the planet, is quite substantial), debt has allowed many of us to better our lives in important ways. Perhaps it paid for the education that allowed us to dramatically increase our income. Maybe it allowed us to buy a fantastic place to live our lives. Or perhaps it allowed us to start our own small business or practice.
Imagine having to save up the entire cost of your house prior to buying. Imagine not going to school unless you were from a wealthy family. Imagine being stuck as a poorly paid employee because you don't have access to the capital needed to hang out your own shingle. Imagine having to turn down a great job because you couldn't borrow a few thousand dollars to get a reliable used car. Debt is one reason for the economic success we enjoy as a society and as individuals.
Centuries ago (surprisingly few), the consequences of defaulting on your debt were dramatically more severe. Debtor's Prison was a real thing, even in the United States, into the 1840s. If you didn't pay your debts, you literally went to prison until you or someone on your behalf paid them. Corporations and personal bankruptcy protections are relatively new in the history of the world. So it is no surprise to see the great religious books of the world warn profoundly about debt.
Both Jewish and Christian people derive wisdom from this book. What does it say about lending and borrowing? Quite a bit.
The rich rules over the poor, and the borrower is slave of the lender. (Proverbs 22:7)
Be not one of those who give pledges, who put up security for debts. If you have nothing with which to pay, why should your bed be taken from under you? (Proverbs 22:26-27)
The wicked borrows but does not pay back, but the righteous is generous and gives. (Psalms 37:21)
At the end of every seven years you shall grant a release. And this is the manner of the release: every creditor shall release what he has lent to his neighbor. He shall not exact it of his neighbor, his brother, because the Lord's release has been proclaimed. (Deuteronomy 15: 1-2)
You shall lend to many nations, but you shall not borrow. (Deuteronomy 15:6, 28:12)
If you lend money to any of my people with you who is poor, you shall not be like a moneylender to him, and you shall not exact interest from him. If ever you take your neighbor's cloak in pledge, you shall return it to him before the sun goes down. (Exodus 22:25-27)
Whoever puts up security for a stranger will surely suffer harm, but he who hates striking hands in pledge is secure. (Proverbs 11:15)
One who lacks sense gives a pledge and puts up security in the presence of his neighbor. (Proverbs 17;18)
You may charge a foreigner interest, but you may not charge your brother interest. (Deuteronomy 23:20)
Christians find that the New Testament is also anti-debt. The focus is more against borrowing than lending but also against profiting from lending.
Owe no one anything, except to love each other, for the one who loves another has fulfilled the law. (Romans 13:8)
For which of you, desiring to build a tower, does not first sit down and count the cost, whether he has enough to complete it? (Luke 14:28)
Give to the one who begs from you, and do not refuse the one who would borrow from you. (Matthew 5:42)
And if you lend to those from whom you expect to receive, what credit is that to you? Even sinners lend to sinners, to get back the same amount. But love your enemies, and do good, and lend, expecting nothing in return, and your reward will be great. (Luke 6:34)
Give us this day our daily bread, and forgive us our debts, as we also have forgiven our debtors. (Matthew 6:12)
The scriptures and leaders from The Church of Jesus Christ of Latter-day Saints caution heavily against borrowing.
Whosoever borrows from his neighbor should return the thing that he borrows. (Mosiah 4:28)
Pay the debt, and release thyself from bondage. (D&C 19:35)
It is forbidden to get in debt to thine enemies. (D&C 64:27)
Pay all your debts. (D&C 104:78)
Do not get in debt to build the house of the Lord. (D&C 115:13)
More modern church leaders aren't quite as extreme, but they're still definitely anti-debt. J. Reuben Clark, way back in the Great Depression, said (and I paraphrase a bit):
“To buy on the installment plan means to mortgage your future earnings,” President J. Reuben Clark Jr. said in 1938. “If through sickness or death, or through loss of work, the earnings cease, the property bought is lost together with what has been put into it. I venture one suggestion…the ordinary family will do well to purchase by installment only the actual necessities of life, leaving the luxuries to be bought as they can be paid for when purchased. I shall not attempt to draw a line between necessities and luxuries, beyond saying that a [doctor] who can ride to work [in a Honda Civic] would hardly be justified in buying a [Tesla Model S with ludicrous speed] for that purpose on the installment plan.”
and more famously a quote I have used before:
“Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels…it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands nor orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you.”
More recently, Gordon B. Hinckley said:
“I am troubled by the huge consumer installment debt which hangs over the people of the nation, including our own people…I recognize that it may be necessary to borrow to get a home, of course. But let us buy a home that we can afford and thus ease the payments which will constantly hang over our heads without mercy or respite for as long as 30 years…Look to the condition of your finances. I urge you to be modest in your expenditures; discipline yourselves in your purchases to avoid debt to the extent possible. Pay off debt as quickly as you can, and free yourselves from bondage.
Self-reliance cannot obtain when there is serious debt hanging over a household. One has neither independence nor freedom from bondage when he is obligated to others.
Borrowing under some circumstances is necessary. Perhaps some college students need to borrow to complete their education. If you do, see that you pay it back. And do so promptly, even at the sacrifice of some comforts that you might otherwise enjoy. Most persons have to borrow to secure a home. Prudent borrowing may, of course, be necessary and proper in the management of business. But be wise, and do not go beyond your ability to pay.
Reasonable debt for the purchase of an affordable home and perhaps for a few other necessary things is acceptable. But from where I sit, I see in a very vivid way the terrible tragedies of many who have unwisely borrowed for things they really do not need.”
Thomas S. Monson said:
“We urge all Latter-day Saints to be prudent in their planning, to be conservative in their living, and to avoid excessive or unnecessary debt.”
James E. Faust:
“Owning a home free of debt is an important goal of provident living…Homes that are free and clear of mortgages and liens cannot be foreclosed on…Independence means…being free of personal debt and of the interest and carrying charges required by debt the world over.”
Spencer W. Kimball, known for his bluntness, said:
“Get out of debt and stay out of debt.”
Heber J. Grant explained:
“If there is any one thing that will bring peace and contentment into the human heart, and into the family, it is to live within our means. And if there is any one thing that is grinding and discouraging and disheartening, it is to have debts and obligations that one cannot meet.”
The longest verse in the Quran is about debt, part of which reads:
When you contract a debt for a stated term, put it down in writing…let the debtor dictate, and let him fear God, his Lord, and not diminish [the debt] at all. Call in two men as witnesses…Do not disdain to write the debt down, be it small or large, along with the time it falls due: this way is more equitable in God’s eyes, more reliable as testimony, and more likely to prevent doubts arising between you. (2:282)
Allah will deprive usury of all blessing, but will give increase for deeds of charity. (2:276)
More significantly, the prophet Muhammad said:
“If a man was killed in battle for the sake of Allah, then brought back to life and he owed a debt, he would not enter Paradise until his debt was paid off.”
“A dirham of Riba (interest) knowingly taken by a man is a sin worse than committing Zina (fornication) 36 times.”
Devout Muslims take this very seriously, both on the lending and the borrowing side. Every month I receive an email from a Muslim inquiring about unleveraged real estate investments or mutual funds that don't involve receiving interest. They're certainly not interested in bonds or CDs. There are a few mutual funds out that are considered “Shariah-compliant”, and I usually steer them toward those funds.
Perhaps easier to understand by the non-religious are the effects of debt in our society. Consider the following 2021 statistics:
- Average American credit card debt: $6,270
- Total credit card debt: $807 billion
- Total consumer debt: $4.2 trillion
- 45.4% of families carry credit card debt
- In the lowest quartile by net worth, the median net worth is $310 and the average credit card debt is $4,830
- The average credit card debt goes up right along with increased education and increased income
- 777,940 people filed bankruptcy in 2019
- Collection agencies hold $120 billion in medical debt
Most of us know somebody whose life was ruined by their financial debts. Despite all of the good that debt has accomplished, it has certainly left plenty of destroyed lives in its wake. And that's with all of the consumer protections and bankruptcy protections currently available in our society.
A stunning picture shows up when you talk to an industry insider. Banks are literally and constantly running experiments on their customers to figure out how to get them to borrow more money and not pay off the debts they have. You must recognize that there are people in the financial industry whose job is to keep you from building wealth by keeping you in debt.
Benjamin Franklin famously said:
“Rather go to bed without dinner than to rise in debt.”
So one need not be overly religious to be anti-debt.
Clearly, if you expect to chart any sort of moderate course with debt throughout your financial life, you must exercise massive caution to avoid the issues that the wise people above have warned us about for millennia. A large percentage of society would be better off if they NEVER borrowed any money for anything, no matter what the mathematical possibilities of doing so might be.
Some people may find it helpful to have some practical guidelines about how much is reasonable to borrow for various purposes. Here's what I think, though I recognize that some people will disagree with me.
Credit cards, despite the name, aren't for credit. They are a terrible source of credit. The interest rates are high (and sometimes variable), the consequences of missing payments can be severe, and their payment plans aren't actually designed to ever pay off the debt. They should be called “Convenience Cards”. That's a much more accurate name. It is not convenient to go to the bank or the ATM to get cash and then return to the store. It is not convenient to walk around with bundles of green bills. It is not convenient to buy an airplane ticket over the counter.
Enter the credit card—easier to use, safer to use in many ways, and, so long as it is paid off at the end of the month, all this convenience doesn't even cost you anything. In fact, due to some credit card rewards programs, you might even be getting paid to use the card instead of cash.
But let's not kid ourselves. Banks aren't stupid. They're doing just fine. Forty-five percent of Americans actually carry a balance on their cards. Plus, companies that take credit cards are paying fees. Those fees are generally higher than the rewards the banks pay out. Why do companies (including The White Coat Investor) accept credit cards? Because we know you, the consumer, is far more likely to buy and buy more if we let you use a card to do it. But guess who pays the costs of taking on the credit cards? That's right, you, the consumer. Everything you buy costs 2-3% too much because it is usually bought on credit cards.
That's not even considering the behavioral finance aspects. Study after study shows that we spend more when we use a card. Besides the convenience and the actual credit, it's less psychologically painful than parting with a big pile of the green stuff. If you're having trouble getting your savings rate up to 20%, one of the best ways to fix the issue is to cut up your credit cards.
At any rate, whether you choose to use cards for your purchases, there is no doubt that they are not for credit, they are merely for convenience. So the acceptable ratio of revolving debt on credit cards is 0. Zero. Zilch. Nada. If you're carrying a balance on your credit cards, you are failing at this finance game and probably should not use credit cards at all. Ever.
I get plenty of pushback on my attitude and ideas about cars. People think I'm bonkers for getting anywhere near an automobile that wasn't sold in the last six months. I've been told that I don't care about my family or the planet. But if you want my advice on the maximum amount to borrow for a car, my answer is less than $10,000, and I'd rather see it closer to $5,000. Yes, that's even if it is a 2% loan. Yes, that's even if it is a 0% loan. Debt aficionados have unsuccessfully tried to convince me that borrowing for a car was their secret to financial success. Here is one of my all-time favorites: A doc tried to convince me of the wisdom of buying a car on credit and then borrowing against it multiple times. The doc even tried to convince me on buying an “exotic” car.
If your plan to build wealth and support charity is to buy an exotic car, you may have your priorities a bit mixed up. If you wanted $250,000 to invest in real estate, then don't buy the car first and then borrow against it. Just invest it in real estate. I guarantee you'll have more to invest in real estate and give to charity, but you'll have to find somewhere else to network besides the track.
If you have $10,000 or more in cash and need a car, pay cash for the car and limit your purchase to the cash you have. If you don't have $10,000 and need reliable transportation, drive a car that costs less than $10,000 until you do.
Lots of people hate my car advice and point out that they're successful despite not following it. Well, duh. You make $300,000 a year. That sort of income can cover up plenty of financial mistakes; that doesn't make it any less of a mistake. One mistake that a doctor's income cannot cover up, however, is taking out massive amounts of student loans relative to future income. Too many people believe they can borrow the entire cost of education at a very expensive school, choose a lower-paying specialty, and take a crummy paying private job within that specialty and still think that everything is going to work out just fine. Guess what? You don't get a pass on math.
It doesn't matter how wonderful your heart is. If you make bad financial/career decisions, you're not going to be financially secure, much less successful. I'm not saying you can't be a family doctor or a pediatric endocrinologist unless you have some family money paying for school. I am saying if that is your career goal, you need a student loan plan that aligns with that career goal. That plan might be living very frugally and then combining a particularly high-paying job in a low cost of living area with living like a resident for five years after training so you can pay off those loans. That plan might be spending some time in academics after training so you can qualify for PSLF. That plan might even be making 20 years of PAYE payments while simultaneously saving up a tax bomb fund on the side. But you can't stick your head in the sand and hope for the best.
Here are some ratios I commonly give for education. The first part of the ratio is the size of your student loans at the time you finish training. The second part of the ratio is your gross income within a couple of years of finishing training.
At 1:1 or less, you have made a good investment. We're talking about having $250,000 in student loans and a job that pays $250,000 a year. By living like a resident, you can pay off this debt within just 2-3 years and then enjoy that great income for the rest of your life.
At 2:1, the deal is still acceptable, although I would argue it isn't really a good deal. This is the maximum level of debt I recommend. If you want to be a veterinarian and expect to make $75,000 when you get out, you had darn well better not borrow $300,000 to go to school. If you will limit your ratio to 2, you can still pay off your debts if you live like a resident. You just have to do it for longer. Consider a doc making $300,000 a year who owes $600,000. After tax ($75,000) and living a little better than a resident ($75,000), that leaves $150,000 a year to put toward the debt. You should get rid of it within five years.
At 3-4+:1, you no longer made a good investment. You might be saved by having your debts forgiven—either tax-free via PSLF by working full-time for a 501(c)(3) for 10 years or by taxable (save up for that tax bomb) via IDR forgiveness by making PAYE payments for 20 years (or REPAYE for 25 years). However, it is very hard for me to recommend a career path with so much legislative risk. You need to fix the ratio. Either don't borrow as much or (probably more likely) simply get a better job. Most of the doctors with these sorts of ratios have the lowest quartile income for their specialty. With a higher income, they may be at a 2:1 or even better ratio. They usually have an income problem that is larger than their debt problem.
I have two general rules for mortgages for those who need some guidelines.
- Limit the size of your mortgage to twice your gross income
- Limit all monthly housing expenses (mortgage, property taxes, insurance, utilities, maintenance) to less than 20% of your gross income
Pretty straightforward, right? And remember, that's the maximum, not the goal. So if you want an $800,000 house but only make $300,000, you need to put $200,000 down. If you're using a doctor's loan and only putting $10,000 down, you should go find a cheaper house.
If you live in a very high cost of living area, you probably find that advice to be depressing. If you're a doc making $180,000 in the Bay Area, I basically just told you that you will never buy a house within a three-hour drive of your job. In these sorts of areas, I think it is acceptable to stretch that ratio from 2X to 3-4X, but not to 10X. You do not want to be house-poor, even if that gamble occasionally works out for someone. If you go for that stretch, realize it has serious financial implications on your ability to build wealth, and it will need to be made up for somewhere else in your financial life—no private school, less frequent vacations, crummier cars, later or less luxurious retirement, etc.
For second homes such as a lake home or ski condo, I would like to see you pay cash for them, but I think it is acceptable to borrow some of the cost. The main thing is to view this home, like your main home, as a consumption item, not an investment. If you can afford all of the costs of the second home and still save adequately to reach your goals, it's OK to buy. But a larger down payment than when you originally got into your house seems appropriate. If the market turns (and it can turn hard on vacation properties), you don't want to be underwater. You want to be able to sell it, pay off the mortgage, and walk away.
Renovations can also be very expensive, and they are usually at least partially paid for with debt. My guideline here is to borrow no more than the increase in value of your home from the renovation. This is likely 50% or less of what you spend. Kitchens and baths return a little more; landscaping, garages, and “unique” renovations return a lot less. Some renovations (like a pool) can even be a liability in the view of some future buyers.
A home is likely the most expensive purchase of your life. Don't spend too much on it, especially if you're using borrowed money to do it.
I don't really think you should borrow at all to buy other stuff, whether that is a boat, snowmobiles, four-wheelers, furniture, rugs, paintings, or anything else. I find purchasing those items so much more enjoyable when I can pay for them just once and know that it is paid off. Those items will probably depreciate, but if I get into trouble, they're now actually a blessing in my life (since it can be sold for something) instead of a curse (because it requires ongoing payments from my cash flow).
There is an idea prevalent in personal finance that there are good debts and bad debts. The basic idea is that debt that increases your income (student loans, business debt, practice loan) or allows you to buy an appreciating asset (home, practice, an exotic car (?)) is somehow a good debt and that anything used to purchase a service or consumable good or depreciating asset (credit cards, auto loans, furniture loans) is bad debt. This is a pretty superficial understanding of debt. For example, which one is the bad debt:
- $800,000, 6.8% student loan
- $4,000, 2% car loan
I can tell you which one I would rather have, yet that student loan is somehow always placed in the “good debt” category. That's not to say that some debt has higher quality than other debt, but we'll get into that a little later.
The truth is that debt, like money, is fungible. Whether the debt was originally taken out to pay for a car, school, a house, or ice cream cones really doesn't matter. Once you have it, it's debt. And when you have debt, anything and everything you purchase instead of paying off that debt is exactly the same as purchasing that service or product on the same terms as the highest interest debt you have already.
WHOA! MIND BLOWN!
That's right. If you're in debt, everything you buy is on credit. Your groceries, your cell phone bill, your vacations, your car…everything. That mindset might help you to get yourself out of debt a little faster.
“Would I borrow at 3.5% for this? Probably not, so I won't buy it.”
Since most people in our society have debt, well, most of our society is borrowing for everything. I suppose that's not necessarily bad, but it is an interesting way to look at the world.
As noted above, there are people who are so anti-debt that they basically think you should never have any debt whatsoever. However, when you really press them, you find out they are taking on debt. They're just calling it something else. One of my favorite workarounds is the concept of an Islamic Mortgage. How do devout Muslims buy a house if they can't borrow? They get an “Islamic Mortgage”. There are three types:
Ijara: The bank purchases the property and leases it to you for a fixed term at a fixed monthly price. Then the bank gives you the property and puts the home in your name after you repay the lender.
Musharaka: You and the bank each own a separate part of the property. When you make a payment, part of it is capital and part of it is rent, and the bank gives you a little more of its share of the property. Your rent, just like the interest portion of a payment, gradually goes down as you work your way through the term.
Murabaha: The bank buys the property. Then it sells it to you at a higher price which you will pay in installments over a fixed term. Basically, it just works the interest/profit into the purchase price.
If there is anybody who is almost as much against debt as devout Muslims, it's radio talk show host Dave Ramsey. The only debt that he thinks is OK (although not encouraged) is a 15-year fixed mortgage with a 20% down payment where the monthly payment is less than 25% of your take-home pay. Dave thinks you should not even borrow for your education. I actually think it is pretty reasonable to get through an undergraduate education without borrowing. With careful school selection, application for scholarships, hard work during the summers with part-time work during school, and maybe even a little parental help, I still think one can get an undergraduate education without student loans.
However, that all changes when it comes to expensive professional schools like medicine and dentistry where the cost of attendance typically ranges from $50,000-$100,000 per year. You just can't expect a student to make that with a part-time job. Plus, there are (almost) no summers to work, and there are far fewer scholarships.
Saving up to go to medical school is not very wise. You could work for 15 years to save up the funds to go and then miss out on 15 years of a physician's income—not to mention a big chunk of your life where you aren't doing what you want to do. It's far smarter to borrow for it; you just have to make sure you are only borrowing a reasonable amount and that you have a plan to take care of it in a reasonable period of time afterward. Yes, there will still be a few students who are really hosed when they do not match repeatedly, but for the most part, it's a pretty smart investment, even with borrowed dollars.
Dave's proposed solution for paying for medical school is to do what I did—sign a contract instead of borrowing money. However, like an Islamic Mortgage, this is just debt by another name. The three main contracts that people sign are:
- Health Professions Scholarship Program (HPSP)
- National Health Service Corps (NHSC)
- MD/Ph.D Programs
With each of these programs, your tuition, books, and fees are covered, and you are provided a living stipend. Awesome! A “scholarship” right? Not really. All you have done is signed an indentured servitude agreement. Centuries ago, people came to America as indentured servants. Their employer paid the costs for them to emigrate, and then they were obligated to work for that employer—usually very hard and for not much money—for seven years. That sounds an awful lot like these programs.
With the HPSP program—in exchange for paying for you to get an MD, DO, DDS, or DMD—you have to go through the military match, live where they tell you to live, and be deployed wherever they tell you to go for four years. The pay is significantly less than the average for most specialties. In essence, they just gave you part of your salary upfront. Now the deal is better for some people than others (more expensive school, lower-paying specialty) but it's rare for someone to come out dramatically ahead financially for taking this deal. You certainly do not finish school “debt-free”, except by the narrowest definition of debt. Most doctors, if they live and work similarly to how they must live and work in the military, could retire substantial medical school loans in less time than it took to pay off their military commitment.
The deal with NHSC is similar. While there is no NHSC match or deployments, they certainly limit the specialties you can practice and the physical location and type of practice for four years afterward. The pay is also relatively poor (about $160,000 these days).
With an MD/Ph.D, you take the first two years of medical school, and then you hit pause to earn a Ph.D. That Ph.D may take anywhere from 3-7 years before you start your third year of medical school. Yes, school is paid for and you earn a stipend, but your opportunity cost is a half-decade of attending physician income. In essence, you're getting part of your pay upfront in the form of waived tuition.
The bottom line with each of these programs is that if you're going to do any of these things (military service, work in a rural or underserved community, or get a Ph.D) anyway, you should enroll in these contract programs. But you should not do any of them just to avoid medical school loans.
When building a portfolio, debt functions as a negative bond. Just like a bond provides a low-risk fixed return, so does paying off debt. While bonds do lower overall portfolio volatility and perhaps assist investors in staying the course in a market downturn, there is no mathematical reason to hold a bond paying 2% while you have a 4% mortgage or a 7% student loan you could pay off instead.
On a similar note, many people advocate for a 100% stock portfolio—no bonds. They argue that it provides the highest return. My question for them is, “Why stop at 100%? If 100% is good, why isn't 120% or even 150% better?” How do you get to stock percentages greater than 100%? Well, since debt is a negative bond, you get there by borrowing money and investing it. Many brokerages will let you borrow against your portfolio, sometimes at surprisingly low but typically variable rates. You can borrow up to 50% of the value of your portfolio. Most would recommend against a ratio that high, since when you are that highly leveraged, any drop in the value of the stocks will trigger a margin call. But if you borrowed 20% of the value of your portfolio, you could get to 120% stock portfolio pretty easily.
Frankly, since money is fungible, if you have any debt at all, it's like you're investing on margin already. While investing in stocks on a 2% margin might seem somewhat wise, investing at an 8% margin using some crummy student loan or a 15% margin using a credit card does not.
It's pretty easy to understand how borrowing at 2% and investing at 10% works out well in your favor. Imagine you borrow $10,000 at 2%. Each year you owe $200 (2%) in interest. But you may earn $1,000 in interest (10%). Before taxes, you've made $800. After taxes (let's assume a 35% marginal tax rate), you've made $520. If you itemize, you may be able to deduct that $200 in interest too, so your true after-tax return is $520 + $200 * 35% = $590. It seems pretty good to get a “free” $590. However, remember that you don't get 10% from a risk-free investment. If that investment had lost 10% of its value instead of earning 10%, instead of gaining $590 after-tax, you would have lost $1,200 ($780 after-tax).
None of that really seems worth all the hassle of dealing with a loan, but what if we made the loan a lot bigger? What if we borrowed $1 million instead of just $10,000? Now we're looking at a possible $59,000 gain with a 10% gain and a $78,000 loss with a 10% loss on the investment. More money doesn't make someone a different person. It just makes them more of what they already are. In the same way, more leverage doesn't change an investment, it just makes it more of what it already is. If it was going to perform well before, it is now going to perform really well and vice versa. However, when you don't really know in advance how something will do—and with the added concern of margin calls—it seems an ounce of caution is in order.
While we're on the subject of investing on margin, it's worthwhile to point out that most real estate equity investments are purchased on margin. Leverage, i.e. the use of debt to buy the investment, is routinely used, primarily to facilitate the raising of capital but also to boost returns. In our example above, we just looked at $10,000 and $1 million in borrowed money. But with most real estate investments, the purchase is only partially completed with borrowed money. Many investors wonder how much they should borrow. They want to be protected and to get out of the investment without bringing money to the table if it all goes bad, but perhaps more importantly, they want the investment to be cash flow positive so they can hold on to it long-term even if its value drops temporarily.
No matter how much money you make at your day job, you can only carry so many negative cash flow properties for so long before you go bankrupt. But you can carry an infinite number of cash flow positive properties.
You can figure out your required “cash flow positive down payment” by running the numbers on your investment, but most of the time, you're going to come up with a number that suggests you put down 25-35% of the investment on any halfway decent deal. With that size of a down payment, a decent property should be cash flow positive. You will also notice that most private real estate syndications and funds use about the same amount of leverage.
Consider a $100,000, cap rate 4-6 property (meaning if it were paid off, it would provide a $4,000-$6,000, 4-6% cash-on-cash return to the investor). If, after all of its costs, it can generate $4,000-6,000 in cash, then it suggests you could pay up to $4,000-6,000 in mortgage costs and still avoid a negative cash flow situation. If you get a 30-year fixed mortgage at 5%, your annual payments would be as follows at the various cap rates:
As you can see, whether a property cash flows depends on three factors: interest rate, cap rate, and down payment. With a 5% interest rate and a 4% cap rate, you need to put down a lot of money, 40% in this case, to ensure positive cash flow. When the interest rate and cap rate are equal (5% in this case), the property cash flows with a 25% down payment. When the cap rate is higher than the interest rate, you can put down as little as 10% and still have positive cash flow. As I write this , cap rates in various cities across the country average at most 3-4%, and investment property interest rates are in the 3.5-4.5% range, suggesting you'd better plan to put down at least 25-33% as a down payment to stay cash flow positive—and a whole lot more than that in Miami or Naples, Florida.
This is the most common question I get, particularly from new attendings who have more great uses for cash than they have cash. I have written about it many times, but this particular question does not lend itself to easy answers. It always depends, and there are a lot of variables:
- Attitude Toward Debt: The more you hate debt, the more you should pay it down.
- Interest Rate of Debts: The higher the interest rate, the more you should pay it down.
- Deductibility of the Debt: If interest is deductible, it lowers the effective interest rate.
- Presence of an Employer Match: Not getting the match is leaving part of your salary on the table.
- Whether You Expect Loans to Be Forgiven: Don't pay off loans that someone else will pay off.
- Available Tax-Advantaged Retirement Accounts: Tax and asset-protected accounts are particularly valuable places to invest.
- Available Investments, Desired Asset Allocation, and Expected Returns: The more you expect to make on your investments, especially adjusted for risk, the more likely it is that you should invest instead of pay off debt.
- Financial Goals: If you want to pay off your student loans in two years or your mortgage in seven, you need to pay more than the minimum required payment.
Here is a priority list that may help guide you that no one will argue with too strenuously:
- Get any employer match
- Pay off high-interest rate debt (8% or more)
- Max out available retirement accounts
- Invest in assets with high expected returns
- Pay off moderate-interest rate debt (4-7%)
- Invest in assets with moderate expected returns
- Pay off low-interest rate debt (1-3%)
- Invest in assets with low expected returns
Honestly, the most important thing is not exactly what your money goes toward. Paying down debt is a good thing. Investing is a good thing. Both build your net worth. The most important thing is how much of your income goes toward building wealth either by paying down debt or investing. Concentrate on that.
I find it interesting to talk to wealthy people about how they did it. The same drive that leads the wealthy to save money in order to invest it also drives them to save money in order to pay down debt. In my experience, rich people do both, middle-class folks try to decide whether to pay down debt or invest, and the poor do neither. There's probably a mindset lesson there.
My family chose to be debt-free. We paid off our mortgage in 2017 and haven't looked back. In some ways, it's just a status symbol. By doing it, we get to make videos like this one:
There are some benefits of being debt-free besides just a status symbol. These include:
- No need to justify your debts
- You're not buying anything on that fungible debt
- Better cash flow since no money has to go to payments every month
- Can't go bankrupt
- Carry less life and disability insurance
- Use a more aggressive asset allocation
- Take more career risks
- Take more side gig/business risks
- Simpler financial life
- Don't have to care about your credit score, credit limits, interest rates, and loan-to-value ratios
- Build wealth-building muscles – Paying off student loans or a mortgage is a trial run for saving up for financial independence
Some people consciously and deliberately choose not to seek the debt-free life for financial reasons that have nothing to do with overspending. They note that debt has a substantial number of financial benefits including increased investment returns, less overall risk, and lower taxes. In this section, I'll explain how that can be, as well as provide some guidelines as to how you can profitably incorporate debt into your financial plan without taking unsafe risks.
As we discuss debt and its uses, it is important to understand the characteristics of any given debt before you decide to incorporate it into your plan.
- Long vs. Short Term: You do not want to purchase a long-term investment using a short-term loan. If the investment falls in value when the loan comes due, you could be up a creek without a paddle.
- Low-Interest Rate vs. High-Interest Rate: It is much easier to out-invest your loan interest rate when that rate is low.
- Fixed vs. Variable: A debt can either have a fixed interest rate or a variable interest rate. With a fixed rate, you generally accept a higher interest rate to eliminate the possibility of the interest rate rising. In essence, you are paying the lender to take on interest rate risk for you, almost as if you are buying an insurance policy against rising rates. With a variable rate, you are taking on that risk yourself and saving those “insurance premiums”, although sometimes if rates fall, you can actually end up with an even lower rate. When you are using debt to purchase long-term investments, however, a fixed-rate loan generally carries significantly less risk than a variable-rate loan.
- Secured vs. Unsecured: A given debt may be secured by some sort of collateral. Auto loans are generally secured by the car itself. If you stop paying, it will be repossessed. Likewise, mortgages are generally secured by the value of the property. If you default, the property will be foreclosed on and taken away from you. Margin loans are secured by the securities in the account. However, there are many debts that are not secured such as student loans or credit cards. When you are using debt to purchase long-term investments, an unsecured loan would be more attractive than a secured one. However, the interest rates on unsecured loans are usually substantially higher than a secured loan. For most who are borrowing in order to invest, the lower interest rate will trump the benefits of having an unsecured loan.
- Deductible vs. Non-deductible: If loan interest can be deducted on your taxes, it lowers the effective interest rate on the loan. Thus, a deductible loan like a mortgage; margin loans; or, for low earners, up to $2,500 a year of student loan interest is more attractive than a non-deductible loan, all else being equal.
- Callable vs. Non-callable: If you have debt that can be called at any time by the lender, it is very hard to take much risk with that money. A non-callable loan is far more attractive for long-term investment purposes.
As you can see, the ideal loan to carry to invest is with a long-term, fixed-interest rate, unsecured, deductible, non-callable debt. Unfortunately, there is no debt that meets all of those characteristics. The usual choices are:
- Mortgage Debt: Long-term, low-interest, fixed, deductible, and non-callable, but secured
- Margin Loans: Long-term, low-interest, and deductible, but variable, callable, and secured
- Student Loans: Long-term, fixed, non-callable, non-secured, but mostly non-deductible and may have high interest
We've talked about how investing on leverage can raise returns, but investing is not just about returns. It is also about risk control. When you take on debt, you introduce leverage risk into your portfolio. Investing is a single-player game: you against your goals. You should ask yourself, “How much leverage risk do I need to take in order to reach my goals?” Many high-income professionals like doctors will appropriately conclude that they don't need to take any leverage risk at all, but some do because they had a late start, don't want to save much money, or simply have particularly aggressive goals.
However, what if you could take less overall risk by introducing leverage risk to the portfolio? There are other risks in investing, such as market risk, sequence of returns risk, liquidity risk, and inflation risk.
Thomas J. Anderson points out in his Value of Debt books that there are two ways to get to a 9% return. The first is to invest in assets that return 9%. The second is to invest in assets that return 6% but leverage them with debt. It is possible that you can have a lower volatility portfolio with debt than without. So while you have introduced leverage risk, you have reduced market risk.
One of the biggest risks in retirement is sequence of returns risk. This is the risk that despite having adequate average returns over the investment period, the retiree runs out of money because all of the crummy returns came first and decimated the portfolio while the retiree was withdrawing from it to live. This risk is highest right around the time of retirement, perhaps the last two or three years before you retire, and the first 5 years afterward, because that is when the portfolio is largest. By using debt earlier in the accumulation phase and perhaps later in the decumulation phase, you can spread out the amount of time that such a large part of the portfolio is exposed to market risk.
Rather than decreasing your asset allocation around the time of retirement, you simply reduce your leverage risk around that time. Alternatively, rather than selling low if stocks plummet shortly after you retire, you simply take out a margin loan against the remaining assets and spend that, so you do not sell your stocks low. Later, when the portfolio recovers, you can sell the stocks and pay off the loan.
Sometimes people run into liquidity risk. They simply need cash now and despite being wealthy, they have no cash. It might be tied up in long-term, illiquid investments or perhaps it is just in volatile investments, like stocks, they do not wish to sell while they are down in a bear market. Cash obtained from borrowing can provide cash and liquidity in these times.
Another big risk retirees face is inflation risk. This risk is much lower for accumulators, because they have jobs with wages that tend to rise with inflation and because they also have fixed debt that becomes easier to pay off in the event of high inflation. Retirees can also protect their nest egg with long-term, non-callable, fixed low-interest rate debt. It works exactly the same way. There is obviously a cost to this protection (the interest), but that can be offset or even superseded by additional investment earnings from the borrowed but invested money.
Most of us also face substantial liability risk. Debt can also improve our asset protection. For example, in some states very little home equity is protected. If you have another place to put that money that has better asset protection (retirement accounts or, in some states, a whole life policy), you could “equity-strip” that home equity out with a mortgage or HELOC and move it into the better-protected vehicle. Likewise, you could maintain loans against investment properties inside LLCs to limit the amount of money available to a creditor of the LLC. A margin loan against a taxable account could work similarly.
Thus, there are a number of strategies and circumstances where additional debt could actually lower your overall risk instead of increasing it.
A really cool aspect of debt is that it provides spendable cash without any tax consequences. You can borrow against your house, your car, your investment account, your rental properties, or your whole life insurance policy and get a lump sum of non-taxable cash. It isn't income. It's debt. So, you don't have to pay taxes on it. In fact, when combined with the step-up in basis at death on your house, investment account, or rental properties, or the tax-free death benefit of a whole life policy, there are no taxes due for you or your heirs for the use of that money.
Essentially, one can elect to pay interest instead of taxes. People accuse the wealthy of doing this to avoid paying “their share” of taxes, but in reality, it is a tax strategy available to all of us with anything to borrow against. It isn't always the right strategy—particularly if the interest rate on your debt is high, life expectancy is long, and the basis on your asset is also high. But it is silly for someone on hospice to sell low basis investments instead of just borrowing against them.
In retirement, you don't really need income. What you need is spendable money. The things you pay for do not care where the money to pay for them came from. It can be borrowed money, it can be tax-free Roth IRA money, it can be partially taxable withdrawals from your non-qualified account or Social Security, it can be tax-sheltered income from investment properties, or it can be fully taxable withdrawals from a tax-deferred account. The choice is yours, but there can certainly be times where the right option is borrowed money.
If you subscribe to this idea that borrowed money can boost your returns, lower your risk, and decrease your taxes, you will eventually come around to two questions. The first is what debt you should actually carry. There are lots of options here, including auto loans, RV loans, parental student loans, and more, but most people settle into some combination of
- Margin Loans
- Student Loans
- Loans Against Whole Life Insurance
As I mentioned before, money and debt are fungible, so it doesn't really matter what secures the loan so much as the characteristics of the loan—term, interest rate, security, deductibility, and callability. You can even take out debt on stuff that your kids are using as a method of transferring money to them during your life.
The second question you will run into is how much debt you should take on. I briefly mentioned Thomas J. Anderson above, who has spent far more time thinking about this question than I have. He basically advocates that individuals act like corporations do and take on an optimal amount of debt. His conclusion? That your debt should get to within 15-35% of your total assets by the time you are within 20 years of retirement. Then you should maintain that “optimal ratio” throughout retirement as best you can through spending, taking out additional loans, and trying not to pay down the loans you have by using interest-only mortgages.
So if you have a $600,000 house, $1 million in retirement accounts, a $400,000 rental property, and a $1 million taxable account ($3 million total), he recommends you have somewhere between $450,000 and $1.05 million in attractive debt. Not too much, not too little. Adjust to your own taste, debt tolerance, and debt availability.
But Anderson is advocating for “enriching debt”—debt that helps you get richer. He's not talking about working debt (needed student loans, practice loan, needed mortgage, needed small car loan) or oppressive debt (that 29% credit card and fat 8% car loan keeping you poor). Plus, his books are so full of cautions about who should actually attempt this that it leaves you wondering whether you're even in that elusive group. Should you be like Katie and me, pay off your debts, and live the debt-free life? Or should you seek a moderate path and carry substantial debt to the grave in hopes of boosting returns, lowering risk, and decreasing your taxes? I cannot say, because the answer depends too much on you. Different strokes for different folks. Here are some considerations as you decide, however.
I will use some of Thomas's rules and some of my own.
#1 Do You Have a Religious, Moral, or Social Issue with Debt?
Are you a devout Muslim, evangelical Christian, or a member of The Church of Jesus Christ of Latter-day Saints? Carrying debt into retirement probably isn't compatible with your religious beliefs, nor is it required for success for most high-income professionals. This approach probably isn't for you.
#2 Are You Psychologically Capable of Handling Debt?
The vast majority of people clearly are not capable of handling debt well. I mean, 45% of Americans are carrying credit card debt month to month. This is not a good plan for them. If you're used to borrowing to buy cars, boats, and other consumer goods, this may not be a good idea for you, either.
In my experience, most doctors are way too comfortable with debt. Most young doctors have ratios that are way over what Thomas would recommend already. Consider a dentist with a $500,000 practice loan, a $500,000 student loan, a $500,000 mortgage, and a $500,000 house. What's that ratio? At least 150%, five times as much as that 15-35% ratio. Even if the dentist buys into the “keep an optimal amount of debt forever” philosophy, he or she needs to really attack that debt and build assets to drop that ratio rapidly.
#3 Do You Actually Have a Method to Get Enough High-Quality Debt?
Maybe you're in a situation where debt is not going to be easy to get. Maybe you're 60, retired with inexpensive cars, a $2 million IRA, a $300,000 paid-for house, no kids, and no taxable account. Where are you going to get a $300,000-$600,000 debt with good terms? You're not. This strategy really isn't an option for you.
#4 Are You Overextended, or Can You Handle the Worst-Case Scenario?
Leverage risk is real and sends people to bankruptcy court all the time, even previously successful real estate investors. What happens if you lose your job and the stock market drops 75% and the value of your home drops 40%? Are you still OK? Can you still pay all of your living expenses? Can you still make your debt payments? If not, your debt ratio is too high, even if it is in the 15-35% range.
#5 Is the Debt Actually Part of the Plan?
We're all human. We get tempted to buy stuff we shouldn't buy with money we don't have. You might have an opportunity to take on a high-quality debt. But you might already be at your goal of a 20% debt ratio. Therefore, you should not take on this new debt. You don't want to just collect investments and you don't want to just collect debts. They all need to be part of the plan. You need to make sure the other side of the plan is smart, too. Are you borrowing all this money just to put it into Bitcoin, Tesla stock, and inverse leveraged ETFs, or are the investments you are purchasing sensible, long-term investments such as index funds and appropriately priced rental real estate?
#6 Are You Improving the Quality of Your Debt?
The object is to get rid of low-quality (high-interest rate, short-term, non-deductible) debt while building an optimal debt ratio of high-quality debt. It can make sense to borrow against your portfolio or house to pay off credit card debt in order to save on interest rate, but you have to stay within your ratios or you could get in trouble. It would be terrible to lose the ability to service the debt right after converting an unsecured debt to a secured one!
The bottom line is:
- Do you have the ability to do this (morally, psychologically, temperamentally)?
- Do you want to do this (desire)?
- Do you have the means (access to high-quality debt) to do this?
If the answer to any of those is no, I would instead recommend the pathway I have taken—pay off your debts rapidly but in a methodical, rational way and live debt-free for the rest of your life.
What do you think about debt? How have you used debt in your investing life? How have you gotten in trouble with it? Do you plan to pay off your debts in a rapid fashion, in a moderate fashion, or continue to use debt strategically throughout your life? Comment below!
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