This weeks guest post is written by Matthew White with White and McGowan. Their firm is unique in that they handle financial planning exclusively for physicians and dentists.
Equally distinguishing, is that Blake McGowan is not only a financial advisor with the firm, but he’s also a practicing physician. You can read Matthew and Blake’s story here at KevinMD.com to see how the two came together to form White and McGowan more than five years ago.
The firms’ vision aligns well with the Physician on FIRE philosophy of financial independence and retiring early. Their financial planning focuses on the development of passive income during the accumulation phase through a variety of strategies in hopes of allowing physicians and dentists to replace their earned income as soon as possible.
Matthew and his wife Kelly served as foster parents for five years. During that time they met and adopted their two daughters, Eliana and Kate Marie, and had Ephraim, their youngest.
In his spare time, Matthew enjoys building his own passive income, playing instruments, and sitting on the advisory board of “The Call”, which focuses on recruiting families to help children in foster care or in need of adoption.
Matthew offers a point of view on debt that differs from my own. I like a good counterargument, especially when it comes with a hefty dose of mathematics.
The calculations presented are based on past performance, and as we’ve been warned in countless disclaimers, past performance is not indicative of future returns.
The decision to pay down debt or use it as leverage should be based on a number of factors, but Matthew shows us how the numbers have favored the latter option during our lifetimes.
Why Paying Down Debt Aggressively Was the Worst Financial Decision I’ve Ever Made
The title of this article contradicts the ideology many of you have heard over the years from your professors, Church, or parents. Several talking heads condemn the idea of having debt and believe paying off our debt is the path to financial freedom.
So, before we begin, let me get this out of the way: if having debt creates a mental burden for you and keeps you from enjoying life because of the worry it creates, then paying down debt aggressively may be the best path for you.
However, do not mistake this recommendation as consensus with the view that all debt is bad. This is based solely on one’s ability or inability to cope with debt for an extended period of time and is not an affirmation that doing so would create the highest net worth.
There are certain people that need to eradicate debt for their well-being, but the decision is normally based on what is best for the person psychologically, not mathematically or financially. While this may sound like common sense, I believe the real reason debt creates stress is because it’s an unfinished project looming in the distance.
Sadly, I see so many physicians and dentists, driven by this irrational pressure, throwing every dollar they have at debt as a way of self-medicating the anxiety. The panic sets in and because the thoughts about debt have consumed their minds for so long, they believe the only path to mental freedom from debt is to get rid of it as quickly as possible.
To be honest, I’ve always been a little skeptical of conventional wisdom, tradition, habits, and group think. I want to understand the reason, the why, or the how rather than just agree with what I’m told to in order to avoid conflict.
Our survival instincts tell us to go with the herd rather than think for ourselves. We think it’s better to trust in something that many intelligent people align with over taking the risk of isolating ourselves due to our questioning or different beliefs.
In forming my views and beliefs about debt as a financial advisor, this need to question the norm has served me well. I continued to hear the viewpoint that debt is bad, interest is unnecessary, shorten the repayment term, and lower the interest rate as much as possible.
Early in my career, I was simply told these things and didn’t analyze the math behind the statements, so I aggressively repaid debt in my own planning for a time as my discretionary income increased.
The Question that Changed Everything
But one day this question hit me:
“Why would I use a dollar to avoid interest on a decreasing balance over time rather than use a dollar to gain interest on a growing balance over time?”
The interest rate on the debt balance would need to be much higher than the rate of return of my investment in order for the interest avoided to exceed the amount of interest gained over time.
I want to give you three mathematical examples in three categories, so you can see this fleshed out in a transparent way and better understand why I believe paying debt aggressively is a detriment to your financial planning.
One is paying down student loans aggressively, the other is paying down a home aggressively, and the other is a personal example of paying down a line of credit aggressively.
A Line of Credit
Several years ago, I learned that I could assign certain investment accounts and property as collateral. In return, the bank would give me a line of credit with an interest rate tied to the prime rate, which allowed me to borrow up to an agreed upon percentage of the asset’s value.
This intrigued me because I could borrow this money at a low interest rate and use it to buy a property or business that would net enough profit to repay the line of credit quickly. Once the line of credit was repaid by profits, I could borrow from the line of credit again and repeat the same process.
This effectively allowed my money to work in two places at the same time. Rather than cashing out of my investments to buy the property or business, paying the capital gains tax, and absorbing the opportunity cost, I was able to leave my assets invested, untaxed, and use the bank’s money to acquire an income-producing property.
As the investment accounts and property values accumulate, my borrowing capacity and the amount of assets I can acquire continues to grow with them.
My initial thought was to assign my account, use the line of credit to buy an income-producing asset, and use the profits to pay back the line of credit as soon as possible. Once the line of credit was back to zero, I could repeat the process again.
After aggressively repaying the line of credit with the profits for a couple of years, I started to think through the question I mentioned earlier. With curiosity, I grabbed my computer and started calculating what would happen if I added the income to the investment account assigned as collateral instead of using it to reduce the line of credit.
Doing so would allow those dollars to benefit from compound interest over the next 30 years rather than merely avoiding interest on a dollar this year. Even if the rate of return of the investment account is equal to the interest rate of the debt, I would still earn more than I would lose over time because the earning rate is applied to a larger balance each year whereas the interest rate of your debt is applied to a decreasing balance each year.
As an example, if I assigned $250,000 and the bank provided a line of credit equal to 85% of the value, I would be able to borrow up to $212,500.
But let’s assume I only withdrew half of that from the line of credit because the market is volatile and if the account value decreased during a correction, I could still be sure that the amount I owe on the line of credit is less than the account value of the assigned collateral.
So, that would give me $106,250 to use for a down payment on a property or business. Assuming a 20% down payment, this would buy a property or business worth $531,250.
Let’s assume I end the year with $20,000 of income after all loan payments and expenses are paid. I have a choice: I can make interest-only payments on the line of credit and invest the remainder in the investment account, or I can save nothing and use the entire amount to reduce the debt.
The calculation below will show the results of using the entire $20,000 to reduce the debt balance each year. Once the debt is repaid, the $20,000 is then invested going forward. The investment column is not based on a linear average and accounts for market volatility by using actual market returns for the 30 years between 1987 – 2017.
The next chart shows the results if I had made interest-only payments for the next 30 years, held the debt, and invested the remainder in the investment account each year.
Comparing the Results
The calculated cost of using one method over the other is captured in the bottom right hand corner of each table where it shows the total net worth after 30 years.
As you can see, I would have had a net worth of $7,035,550.91 after 30 years had I chosen to pay interest-only and carried the debt balance. Had I used the $20,000 to reduce debt until fully repaid and then saved the income, my net worth would have been $6,308,458.52.
Over 30 years, the impact of reducing the debt aggressively opposed to servicing the interest-only and investing the rest, made a difference of $727,092.39, which if you want to be picky is a present value (assuming a 5% discount rate) of $168,232.78 in today’s dollars.
It is also important to note that I would have been able to borrow up to 85% of the number in the savings balance column minus the debt at any given time. If I were aggressively repaying the debt, I would have the ability to borrow up to $515,843.49 in 2024. But, if I were paying interest-only and saving the remainder each year, I could borrow up to $541,832.50.
Not only would the latter selection increase my net worth by $727,092.39 in 30 years, it also increases my borrowing capacity over time.
This is only an example, and I was paying quite a bit more toward debt than I’ve illustrated here. Once I finished my calculations and realized the long-term loss to my net worth, it hit me that what I was seeing disagreed sharply with those teaching debt repayment as the most noble of pursuits.
Student Loan Debt
When advisors at our firm meet with physicians and dentists, one of the primary questions we get from those transitioning out of training is, “What should I do about student loan repayment?”
The answer they expect from me is normally, “Well, here’s the lowest interest rate you can get by refinancing your loans and the best way to pay the least amount of interest over time.”
Again, this is an oversimplification of what the calculation entails. If you want to figure out the least costly way to repay debt, the calculation requires a consideration of more than just how much interest is paid.
You must also calculate the financial impact of using a defined amount of discretionary cash flow toward aggressive debt repayment instead of investment, just as we did in the previous example.
When creating a plan for a client, we always calculate three different scenarios and we’re primarily looking for which one produces the highest net worth at the end of 30 years. The three scenarios are:
- loan forgiveness
- aggressive repayment
As you will see below, the person selecting aggressive debt repayment misses out on investing for 2 years. In the third year, they finish paying off their student loans, and save $91,132.45.
Most would believe that missing two years wouldn’t have a substantial impact on their overall net worth in 30 years, especially when accounting for the fact that the debt is repaid, and they’ll be able to save more cash flow each year from that point forward.
Unfortunately, the math plays out a different story. If the person chose the second option of refinancing their student loans over 10 years at 4.5%, their net worth would be $826,336.02 higher than the person that set out to aggressively repay their loans.
The third table illustrates what would happen if the person pursued student loan forgiveness. Many are not eligible for loan forgiveness, so bear in mind, this third option is not available to everyone, but what this demonstrates is that even when leaving your fed loans at 6.8% for 10 years, such could be more beneficial for your long-term net worth than the scenario of aggressively repaying your loans.
This isn’t true for everyone. It depends on your loan balance, level of income, and so on, but it was true for this person and could easily be the case for you.
The amount of interest avoided by aggressive repayment did not exceed the amount forgiven and benefits of compound interest from investing early. In July of 2049, the person choosing loan forgiveness would be worth $1,702,720.10 more than a colleague in the same situation choosing to aggressively repay loans.
We have several clients, having been students of the debt-adverse ideology, that have an interest in paying off their homes as fast as possible. The questions come in different forms:
“Should I do a larger down payment?
“Should I do a 10-year, 15-year, or 30-year mortgage?”
“Should I do a physician loan and finance 100%?”
And there are many others. But all of these questions are another form of one question, which is: “Should I aggressively repay debt”?
Whether it’s a large down payment or a mortgage payment on a shorter term, it’s essentially the same question. The table below addresses the age-old debate between a 15-year mortgage or a 30-year mortgage and hopefully, after this example and the others, you’ll feel more comfortable holding debt for an extended period of time as a way of enhancing your long-term net worth.
I guess I just gave away how this calculation turn out, but oh well.
As you’ll see below, the first two lines give us the variables in the equation for a $400,000 loan. Many physicians and dentists will hear that the 15-year mortgage has a lower interest rate than the 30-year mortgage and opt for the lower interest rate.
Under the title “Total Interest” in the chart below, you can see that the person choosing the 15-year mortgage pays $103,126 in interest during the life of the loan opposed to the $282,506 paid by the person choosing the 30-year mortgage, so what more is there to discuss?
Again, oversimplifying this to a discussion about the total interest does not account for how the extra cash flow would have been used by the person choosing the 30-year repayment option. If they intend to spend it, then the analysis is a waste of time but if they plan to invest it, then it factors into the calculation when determining which option is better.
In order to fairly compare one scenario with the other, we must consider how $2,795 per month would be used in both situations over the same amount of time, which is 30 years.
Though the interest rate on the 30-year mortgage is higher, the mortgage is amortized over a longer span of time, so the monthly payment is only $1,895.85, which means the person choosing the 30-year mortgage will have an additional $899.30 each month to invest over the next 30 years.
The person choosing the 15-year mortgage will save nothing each month for the first 15 years (all going to debt repayment) and then save all $2,795 per month for the last 15 years.
If you assume the invested portion grows at 7% each year, the person choosing the 15-year mortgage would have a loan balance of zero and an account balance of $901,873 at the end of 30 years, and the person choosing the 30-year mortgage would have a loan balance of zero and an account balance of $1,090,739.
The person that chose to extend the debt repayment period to 30 years, even at the higher interest rate, ended with $188,866 more than the person that chose to aggressively repay and save more later by utilizing the 15-year mortgage.
In addition, qualified mortgage interest is deductible against ordinary income and who had more interest to deduct over the 30 years? The person that chose the 30-year mortgage.
Now, the market never makes 7% every year, it fluctuates, so let’s see how this comparison would be impacted if the money was invested in a fund mirroring the S&P 500.
The person choosing the 15-year mortgage and investing the $2,795 for the last 15 years in the S&P 500 (1999-2014) would have an account balance of $998,672 at the end of 30 years.
The person choosing the 30-year mortgage and investing the difference between the 15-year payment and 30-year payment ($899.30) for 30 years in the S&P 500 (1984-2014) would have had an account balance of $1,960,166 at the end of 30 years.
A difference of $961,494 over 30 years, and the ability to deduct an additional $179,380 in qualified mortgage interest!
Thankfully, I was able to analyze the math and course correct after aggressively repaying debt for a couple of years, which saved myself the significant opportunity cost of doing so over my lifetime.
At the very least, I hope this will give you a formula to consider when thinking through your philosophy about debt repayment and what’s best for you. Calculating the future cost was enough to ease the anxiety caused by debt and allows me to carry it comfortably for extended periods of time.
Playing out the math was enough for me, but it may not be enough for you. If having the debt is decreasing your quality of life, in spite of knowing a better ending for your net worth is possible, then pay down the debt aggressively and free yourself from that mental burden.
If you can handle adopting a new philosophy, viewing debt as a friend, not a foe, the difference to your family wealth could be significant.
- Debt Free by Forty: Why I Chose to Pay Off My Mortgage
- Paying Off the Mortgage Early is a Mistake I’ll Never Regret
On what side do your preferences lie? Paying down debt or carrying debt and investing the difference? Why do you feel that way?
44 thoughts on “Why Paying Down Debt Aggressively Was the Worst Financial Decision I’ve Ever Made”
As a financial advisor who works with many individuals, families and businesses, including doctors, I disagree with your debt philosophy. There still needs to be a financial plan with a combination of a debt payoff strategy. If all goes well, your plan may or may not work. However, life is not always a straight path and your plan does not include the human factor or the what if factor. Most of my clients that have built true wealth are debt free and have accumulated more wealth being debt free then paying interest. Some people say that there is good debt and bad debt. Good debt is only good when times are good. However, if you have a challenge in your life, you may not be able to make the payments, then your low interest loan becomes a disaster that ruins your wealth, your credit, etc . You can pay off your debts aggressively as well as building wealth. Most of my doctor clients have built massive wealth by being mostly debt free or not borrowing money and buying what they need in cash. Of course, there are opportunities to borrow at low rates, but they pay off the loan over a 3 to 5 year period versus paying off in 10 to 30 years.
I have seen doctors build wealth with the multiple location practices by having debt on those practices and making affordable monthly payments. To then be crushed by the major hospitals building competition next to their medical practice, and then lose everything including, filing bankruptcy.
Debt is debt and the less you have, not only will you not sleep better at night, you build wealth faster. Today almost every doctor I talk to wants to retire within 10 to 15 years after coming out of residency. This is due to them having a taste of the real world and getting burned out seeing patients every 15 minutes and working long shifts and dealing with insurance companies to determine their pay. I help doctors become debt free with a financial plan and a debt reduction strategy, so that they can accomplish the goal of retirement sooner than later by being debt free and building wealth. Or, if they plan to retire later, they can do it and enjoy helping people without the worries and anxiety.
I’m interested in learning more about these low interest loans using investment or other accounts as collateral. Could be an article of its own. It sounds like these loans are more geared towards investment purchases (rental property, businesses). Is it possible to finance a personal home this way for a lower interest rate? My accounts even after the crash could buy my home several times over. So it makes sense a lower interest rate could be offered with liquid accounts securing the loan (in addition to the property itself). But, I’m guessing that’s not actually the way the mortgage market works (at least outside of investment/business loans).
I know that M1 finance will let you borrow a portion of your portfolio you have invested with them. Maybe 35% at an interest rate comparable to a good mortgage rate.
It would be wise to use a normal mortgage product to finance your primary residence, and commercial loans when purchasing rental property because the interest rates are fixed at a low rate for a period of time. Home Equity Lines of Credit secured by property or a basic line of credit secured by an investment account are typically tied to the floating prime rate.
For myself and most physicians, the bank will set the rate at prime plus zero, or minus 25 or 50 basis points. After the Fed cut rates to zero, the prime rate fell from 4.25% to 3.25%. Though the prime rate is lower than fixed rate mortgage loans, the prime rate has been as high as 5.5% in the last three years; therefore, this is not a better solution than financing with a typical mortgage or commercial loan product because the rate fluctuates.
The line of credit secured by the brokerage account is merely producing the money needed to cover the down payment for the investment property, but the rest would be financed by a typical loan product with a low fixed interest rate. Utilizing the line of credit for the down payment prevents the need to sell shares from the market to cover the down payment, allowing your funds to defer long-term capital gains and remain invested. Since 100% of the property is financed by the bank, 15% to 25% coming from the line of credit for the down payment and typically 75% to 85% coming from a personal mortgage loan or commercial loan, it would be wise to use the net earnings from the project to reduce the line of credit in order to widen the gap between the total loan amount and value of the property. Once the line of credit is repaid by the earnings, you can reuse the available line of credit to repeat the process with another property.
This method effectively allows one to acquire rental property with the banks money, pay it off over time with the earnings from the property, and gain ongoing passive income. All while keeping your own money fully invested and maintaining the power to be debt free. If you get tired of the debt, you can always sell shares in the brokerage account, clear the debt on the line of credit, and put the rental property up for sale.
If you’ve paid off your home and you would like to extract a portion of the equity to invest, you can do a cash out refinance rather than using a HELOC, giving you a fixed interest rate instead of a floating rate for the duration of the loan. Once the bank gives you the cash, the money could be invested, and then you could open a line of credit secured by the account with which you could buy property to create passive income through the process described above.
It’s worth noting, most banks will allow you to have a line of credit equal to 75% or 85% of your statement value. They will ask you to maintain that loan to value, so it’s important to proceed cautiously and always borrow an amount that would be comfortable, even if the account was experiencing a recession.
Anyone else troubled by the time period for the loans in the second example? He compared a 15 yr loan beginning in 1999 and a 30 loan beginning in 1984. There was a huge bull run during the latter period. The comparison should be two loans, both beginning in 1984 and the 15y example continuing to invest the mortgage payment for the 15yrs following loan payoff. I doubt the delta would be as dramatic if he truly compared identical time periods. Also, I tend to find that super savers are also super investors, thus more likely to take a 15y mortgage and invest extra money each month. Aggressive debt repayment often begets financial optimization across the board.
“The person choosing the 15-year mortgage and investing the $2,795 for the last 15 years in the S&P 500 (1999-2014) would have an account balance of $998,672 at the end of 30 years.”
The calculations in the article are based on two loans beginning in 1984 and assume the individual choosing the 15-year mortgage continues to invest in the S&P 500 during the following 15 years from 1999 – 2014 as you suggested. Therefore, the delta you’re seeing is correct.
I wanted to clarify this for anyone else reading the article to avoid confusion.
I found this on the Bogleheads wiki that perfectly summarizes the analysis of when to pay debt:
“Usually, you should pay down the loan if the after-tax interest rate on the loan is significantly higher than the after-tax rate you can earn on a comparable bond investment (a low-risk bond investment with duration equal to the time until you will pay off the loan), and you can pay the loan down without any liquidity problems.”
Comparing paying a mortgage to investing in the market is not a fair comparison.
We have sat on both sides of the debt/investing argument. I think that it is different at different points in life. We did pay debt off aggressively when we were young. We now use part of our mortgage and a line of credit as part of our investing. We don’t regret this approach.
The biggest danger with this leveraged investing approach is behavioural. It relies on perfect long-term investor behaviour. Early, when our debt is large, assets smaller, and income just ramping up – it is scarier to see leveraged investments fluctuate. That can drive behavioural error. This is not much of a factor for us now that we have enough assets/income that the debt is relatively small in comparison and could be paid off at any time without much fuss. Easier to stay the course. When we approach retirement and will become less able to simply make money, then the psychology will likely change again.
The other factor for us (may be a Canada issue) is that our mortgage interest is not normally tax deductible. When we took some of it to invest it becomes deductible against our income. Further, my wife can invest it and have it taxed in her hands at a vastly lower rate (we are taxed as individuals and my marginal rate is much much higher). To do this, we needed to pay off debt first and then deliberately re-borrow to invest.
I have come to think of my debts as chains holding be back from financial freedom. If I had all my student loans and mortgage fully paid, I could work a very part time schedule (2-3 days a week) and make more than enough to live well and save. If I kept he debt and invested the difference I would be wealthier, yes but I would still need to work a longer work week for more years to make those payments. The less debt I have the more free I am to enjoy life now.
We are experiencing the lowest mortgage and business interest rates in history; so why would you not take advantage of that fact (so no I would never pay cash for a home); you also get to deduct taxes on that interest (so a 4% rate is really only a 2-3% IR depending on your tax bracket). As for consumer debt and student loans, these IR are generally much higher and are usually not deductible.
Once critical point that was mentioned is that “compound interest is compound interest” whether it is being applied to an increasing or decreasing balance, but this is simply not true. Warren buffet only became a billionaire is his late 50s when he started to make interest on his interest, it’s really only about 40 years into compounding of interest where the curve explodes; this is when the magic really happens. You will never see compounding of compounding when you are paying down debt; worse yet, you’ve missed out on the opportunity cost of this magic by diverting early money towards paying down a mere 2-3% IR.
No matter what investment book you read, they all agree that the market will eb and flow, and that the long term success rate of the US stock market is a ridiculous 9% annualized rate of return (this includes the great depression, 2 world wars and other major wars, several market crashes, and the latest great recession); So continue to deploy money at all times, don’t cash out during a correction, and if you simply stay the course you can double your money every 7-10 yrs.
As for mitigating risk, it is crucial since we all know people whom have been sideline by devastating illnesses; thus I do believe that a hybrid approach is best way, don’t put yourself in a situation where you are at risk for being upside down on your house or business (100% or even 90% physician loans are a good way of doing this). I would favor hybrid leaning toward more money in the market and paying off my 30yr mortgage in about 20 yrs, by annually making an extra payment.
The median house price for doctors is in between $400,000 and $600,000. At these prices, most doctors will not be able to benefit from deducting the mortgage interest.
Buying a $600,000 home in Arizona with a 20% downpayment and a 4% interest rate will result in $19,000 in interest in the first year (and less thereafter) and $5000 in property taxes. That is $19,000+$5000= $24,000: which is the same as the standard $24,000 deduction for married filing jointly. In this scenario, you pay 4% interest and not a “mere 2-3%”.
To be fair, the new law allows interest deduction on up to $750,000 in mortgage debt, which at an interest rate of 4% would translate in $30,000 interest in the first year and you can also deduct $10,000 in property taxes. In this scenario, itemizing will get you $16,000 higher than the standard deduction ($40,000-24,000). Assuming a marginal tax rate of 44%, you would have saved around $7,000 in taxes. You could say you only paid $23,000 dollars in interest, or a little over 3% but not 2%. As the years go by and you pay less in interest, your interest rate starts to get closer to 4% again.
Owing more than $750,000 would result in less interest being able to deduct and thus a rate closer to the original 4%.
Expecting 9% returns in the stock market going forward is a little too optimistic. Those times of average 12% returns in the stock market were coupled with double-digit mortgage rates. Bogle, before he died, and Larry Swedroe (on the latest Boggleheads podcast) are predicting around 5% returns going forward given the current valuations. Long term capital gains of 20% will then bring this 5% to 4%.
So putting money in a house and investing it in the market will give you a similar return but the risk is higher in the stock market and it feels good to be debt-free.
Again, if someone sees any flaws in the numbers above please reply below 🙂
“One critical point that was mentioned is that “compound interest is compound interest” whether it is being applied to an increasing or decreasing balance, but this is simply not true. ”
I agree this point is critical, but I guess it isn’t so simple after all. Maybe it would help us come to the same place if you could show your logic with a simple example.
I showed in the spreadsheet I linked how compounding works the same with a declining balance as it does with an increasing one. I showed that given the same rate, you end up with the same future value. (See the “equal rates” sheet; Cell “U40” shows ending net worth within 0.2% of each other.
The only reason the delta isn’t zero is due to the oversimplified excel calculations). Perhaps you can find my mistake and help me learn what simple thing I’ve got wrong?
Again, I suspect the confusion comes in due to the equal payments, but this doesn’t have anything to do with the way the interest is compounded – you still pay annual interest equal to the rate of the loan times the average balance over the period for each year. Amortizing the loan essentially works the loan backwards in an iterative function to determine what a level payment would be. If you pay extra principle toward your mortgage this year, for example, next year you reap the benefit of paying less interest on the remaining balance. You enjoy this (compounding) benefit for the rest of the life of the loan as each year the principle is lower and, therefore, the subsequent payments yield higher reductions in principle.
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Leverage is awesome when the market is going up. However, it really sucks in 2000 and 2008.
I wonder if the author went through those big downturns with leverage. If you have high income, you could power through those tough years. However, it’s a different story for retirees. No income means you’re at the mercy of the market. You can’t invest more and it’s stressful to withdraw when the market is crashing. I have a mortgage, but it’s not a huge amount. I’ll stick to the middle path.
Young physicians with high income will profit from leveraging.
Leverage is a beautiful thing.
We paid off our primary mortgage early as a cash flow play, even though the interest arbitrage would’ve informed us to not do so, and invest instead. That said, we have no intention of paying off our 2% student loans and rental mortgages anytime soon. OPM all the way…
Thank you for sharing these calculations. I also am in the boat of investing for the long run while holding a mortgage. I also hold mortgages on investment properties in order to increase % returns. I do plan to have the mortgages paid off by the time I retire in order decrease my cash flow needs.
The other reason to hold a mortgage is that it is a fixed nominal payment. Given the existence of inflation, the real value of payments made diminishes over time. The higher the inflation rate, the lower the real value of a mortgage payment.
I’m trying to capture the best (worst?) of both worlds; refinanced to <2.5% over 5 years, plan on paying off the cars and the wife's student debt at the expense of everything but retirement accounts and 529. After that may just let it ride. I've given myself a backstop of 5 years so I don't convince myself to stretch it out ad infinitum, but I don't see any rush to kill myself paying it off faster than that.
Or maybe I'll refinance it in a year at 1.5% and all of this is just blowing smoke. Who knows.
And one would assume that paying off debt would be good for business and boost their credit score faster.
Well not really. Banks thrive on businesses being able to borrow to allow them to create new income, steadily pay towards the loan, have a balloon payment due, and refi; rinse and repeat. But also, if someone is averse to ever borrowing money, who cares about your credit score? I somehow think that people this irrationally averse to sensible borrowing aren’t gonna be churning credit card bonuses.
That’s food for thought and a very good outlook on how banks do things. 🙂
I fall in the rather pay off some debts like home and student loans, because it creates an emotional buffer that helps us feel more comfortable taking risks we might otherwise not take. Out of curiosity, did you run the numbers for putting off all three kinds of debt repayment and investing?
The calculations assume the person will always have the income to service the debt. In my case, working in the technology industry didn’t guarantee steady income. My employer was telling us weekly that we needed to get our billable numbers up or else “heads will roll” (a direct quote).
After several sleepless nights wondering what the heck I would do if I lost my job and couldn’t find another (a real possibility according to former coworkers who couldn’t find anything on a national search), I decided to knuckle down, halt all unnecessary spending, and pay off my mortgage early (it was my only debt). At least then I would be able to pay my other bills and wouldn’t end up losing the farm I’d worked so hard to acquire and develop.
I did continue to invest the federal max into my 401(K) and Roth because equities were “on sale” basically. But everything else left after the bills were paid went towards the mortgage principal. By the time I took my early retirement, my remaining principal was a pittance that I paid off with a portion of my severance check. I have no regrets.
Leverage cuts both ways. Borrowing against the value of your brokerage account and using it as seed money for real estate sounds like a good way to lose your entire life savings.
“The interest rate on the debt balance would need to be much higher than the rate of return of my investment in order for the interest avoided to exceed the amount of interest gained over time.”
“Doing so would allow those dollars to benefit from compound interest over the next 30 years rather than merely avoiding interest on a dollar this year. Even if the rate of return of the investment account is equal to the interest rate of the debt, I would still earn more than I would lose over time because the earning rate is applied to a larger balance each year whereas the interest rate of your debt is applied to a decreasing balance each year.”
Did I miss the part where this was shown in the proofs given? Assuming we’re not include any sort of tax optimization tricks, you have not convinced me with your hard math on this. I believe this conclusion to be incorrect. Whether your balance is growing in an investment or shrinking in a loan, compounding is happening the exact same way. I had a very valuable lesson pounded into my head in physics – don’t worry about negative/positive numbers, just be consistent and let the math do the work! I think part of the reason people get this turned around so much has to do with obfuscation due to level payments via amortization.
I recreated your calculations in the first couple tables and then created a third calculation where the interest rates are the same and came up with no difference between the two. Someone please help me understand what I’m missing. I shared my file here: https://www.dropbox.com/s/pzl2y0u10z7j6v7/payoff%20debt%20vs%20invest%20difference.xlsx?dl=0
p.s. I happen to be in the “invest the difference camp”; I am unlike most and do have the discipline to invest the excess cash, but often consider timing mortgage payoff at FI/RE vs paying minimums indefinitely in conjunction with the hypothesis future short term market returns will not be as high as past performance.
I updated the file to add a comparison on the “contention” tab to also show how paying down a 30yr with double payments makes no difference to paying minimums over 30 yrs.
In so doing, the link changed on me; here is a new one:
I read through your spreadsheet, James, and it appears you’re absolutely correct. Given the same mortgage interest rate and compound growth rate (assuming we’re talking about the same compounding periods), then the end result after the original loan term for net worth is identical whether you pay off the debt aggressively from the start and invest that income after that or pay the minimum on the loan and invest from the start. It doesn’t even matter the length of the loan term as any money that goes anywhere earns (or equivalently “cancels a negative rate”) the same rate over the term length, so the amount you end up with is purely a function of that rate and the amount of savings each period you can pay towards the loan or the investment.
When I made this statement, I was simply thinking through the fact that the total interest paid on a debt, assuming a payment is reducing the balance, is less than the total interest earned on an investment if the interest rate is the same. To accurately reflect what I was thinking, the statement should say “interest paid” rather than “interest avoided”. The first tactic of reasoning (considering interest paid and interest earned) is less sufficient than the latter when answering the question of should you pay off debt or invest. If I repaid $5 dollars of my $100 debt, 5% of $95 is $4.75, which is less than the interest gained if I add $5 dollars to a $100 investment and earn 5% ($5.25). This is the simple result of the same percentage being applied to a higher number versus a lower number each year over time, and further clarifies the logic behind the comment that debt could have a higher interest rate than the return rate and total interest paid could still be less than the total interest earned. However, I realize this thought about the mechanics of interest doesn’t account for the benefit of interest avoided or the investment of increased cash flow once the debt is expired; therefore, it isn’t a useful truth when analyzing this question, other than the fact it started the process of critical thinking.
James is right, if the interest rates are the same and the defined amount of discretionary income is consistently used to reduce debt or invest, the net worth at the end will be the same regardless of the payoff schedule for the debt. Though the thought process was a helpful prompt in leading me to the more comprehensive calculations in the article, simply comparing the total interest paid to interest gained is irrelevant to the point and not a reasonable basis for choosing to allocate cash flow to one option over the other.
With that said, the net worth at the end will only be the same if the loan interest rate and rate of return assumption are the same, and as demonstrated by the comprehensive calculations in the article, that has not been the case when using actual market results over the last 30 years. The returns have been higher, hence the reason for the meaningful difference in net worth between a person choosing to invest in place of aggressively repaying down debt. The question and statement in the article should be revised to emphasize the thoughts above; however, the calculations still illustrate the point of the article accurately, which is that mathematically speaking, the person choosing to allocate their discretionary cash flow to investments would have had a higher net worth than the person choosing to aggressively repay their debts over the 30-year period between 1987 – 2017.
Here are some points to ponder:
1: Bankruptcy only happens to people with debt.
2: It’s fuzzy math to compare a fixed rate on one side of the equation and a variable rate (guess) on the other side of the equation.
3: People almost never invest all of the difference, they spend a good portion of it over time. So the outcome will not be as good as presented on the investment side.
4: People who have lived in each scenario, with and without debt, rarely choose to go back to living with debt once their debt is gone.
5: Once the house is paid off, few people would choose to borrow against it at a low interest rate to invest in the stock market for a potential higher return. It’s a risk not worth taking.
6: Having debt in retirement requires a significant additional amount of money saved to spin off the profits to pay the debt.
Dr. Cory S. Fawcett
Prescription for Financial Success
Good points Dr. Faucet.
I have noticed that taxes have not been mentioned much.
Paying down a mortgage is different from investing in the market due to:
1. Taxes: that 7% in the stock market will be less after taxes.
2. Risk: there is no risk in paying down your mortgage but there is a risk in the market.
So the question is more about risk tolerance. Would you rather take a guaranteed 4% return or a possible -5% to 15% (after taxes) return?
Please someone point at my flaws, as I am seriously considering buying a house in cash soon. Thanks,
Carlos, you will not be sorry you paid cash for your house.
I’m so glad mine is paid off. If you need more info in it you could read my book The Doctors Guide to Eliminating Debt. It is on POF recomended reading list.
Dr. Cory S. Fawcett
Prescription for Financial Success
1. Not all bankruptcy comes from taking out a loan. With our joke of a health care system in this country, plenty of people go bankrupt due to having a sudden, enormous medical bill.
2. It’s not fuzzy math. The compound rate of return on an investment like stocks is a non-uniformly-distributed random variable with a fairly tight long-term expected average. Nonetheless, it’s perfectly valid to use the expected rate, knowing that it necessarily increases your uncertainty.
3. Don’t be like everyone else. Do you as an apparent financial advisor consider yourself to be average with personal finance?
4. Those are typically people who overleveraged and/or undersaved. There’s no good reason to expect that the average reader here would be like this.
5. “It’s a risk not worth taking.”
Why do you give a one-size-fits-all to people? It mathematically is a risk worth taking as it’s not a “potential” higher return but an expected higher return. Most people don’t treat their finances like a business. Maybe they should…
6. This is just dumb.
The calculations are solid. Gasem’s argument to save and pay off later if you need to is rock solid.
The difference is in execution of this long term strategy, which is purely behavior.
Having an iron clad discipline where you will invest the difference to reap the rewards vs. spend that money because there is always something that comes up. This behavior is why most people handle debt poorly.
BTW using this argument, in most markets (esp HCOL), there is no point buying a house from finance standpoint- rentals are so much cheaper. And you can always move if another opportunity comes up.
I think there is one category of debt which absolutely SHOULD be paid off as aggressively as possible: student loan debt. It’s the only debt out there that can’t be cleared either by selling off or surrendering to the creditor the asset guaranteeing it or discharged in bankruptcy, and the amount owed is usually high enough that absent staying in medicine it may not be possible to ever pay it off.
Once the student loan debt is cleared, taking an “ordinary” job at a much lesser salary becomes a viable option. No more debt handcuffs shackling the physician to a medical career!
Other forms of debt are less risky, precisely because if the fecal material hits the rotating blades there are other ways to get out from under the debt burden.
I don’t see any particular increase in risk. What will happen if there is a disaster say 10 years into the investment on a 30 year house mortgage for example? You will have paid about 1/3 of the total fixed cost and you still own the property. In the meantime you have acquired a significant portfolio. If something bad happens, simply cash out, sell the assets and pay off the house. You would be exactly at the same place, with a house and no savings, compared to if you aggressively paid down the house. So what risk did you mitigate by “aggressively paying down debt?” All you did was save a little interest.
Let’s say you’re 59 and intend to retire at 60 and have a portfolio longevity to age 90. Let’s say you save an extra 10K at age 58. Does that 10K make any difference to your retirement? That 10K at age 58 will grow to be 65K in 32 years. If you deposited that 10K at age 30, it will be 330K at age 90. What if you deposited an extra 10K/yr at age 30 for 10 years? Extra 2.4M at age 90. Time in the market matters. The extra 50 bux you saved on interest “paying down your debt aggressively” at age 30 is 60 years of lost opportunity. You HAVE to game the con “sequence” to the end and not just midway.
Dave Ramsey advice is great for getting credit card debt under control, beyond that not so much.
Debt is a like a negative bond, so most things considered, over time you have more because you take more risk.
PoF aficionados with high savings rates can invest and pay off debt. I bet most in non-HCOL areas or with smallish student loans eventually just get sick of the gnats at their ankles and just write a check. Do that when the market is at all time highs!
I aggressively paid of my debt (student loans and mortgage) when I finally “saw the light” financially and I have not regretted this choice one bit. You don’t realize the weight on your shoulders that debt puts on you until it is finally taken off and it is truly freeing, giving you a peace of mind.
Yes, I know I left money on the table with my chosen scenario, especially given the incredible bull run we have had, but the roles could have easily been flipped if we had gone into a recession (and the question is when not if it will happen). That is a gamble anyone takes. Paying off debt is a guaranteed return on your money.
Plus there is a mental shift when you pay off debt. You soon become debt averse and for me a mental switch was turned on and I wanted now to purchase income producing assets rather than income depleting depreciating ones.
I have previously given an example that for those who have a fully paid off home, it is incredibly rare to take on a mortgage just to invest in the market. I am sure people have done it and come out ahead but the uncertainty would make many think it is crazy to do that.
Another fault in the proposed line of thinking is assuming that all the money that would be paid towards debt aggressively would be invested. That might not always ring true as something nonessential always seems to come up to claim some of that money if you don’t have the same aggressive mentality in investing as you do in paying down debt.
I stopped taking your analysis seriously when you talked about leveraging a line of credit to buy a property or business. Perhaps we should retire the phrase “passive income” as a lot of folks seem unclear on the concept…
The rest of your calculations assume markets (stock and real estate) that move in a predictable fashion and only in one direction (up). Not a word about how you manage when the market falls 30% in a year (look it up, it happens) or you’re unable to sell that property and have to pay carrying costs for 2 years… Plenty of other commenters have pointed out the fallacy of comparing fixed rates to variable ones.
But I get it. The people that will read this guest post and scoff at it, aren’t the target audience for your financial advising business.
I agree with Physician Philosopher that a hybrid strategy is probably best. That seems to me like a further form of diversification that will reduce risk. If stocks do well, you get a piece of that return. If stocks do poorly, you get a “guaranteed return” from paying off your debt based on the interest rate. I chose to do a bit of both over the past five years and have been happy that I did not miss out on stock market growth by putting all of my money into student loan repayment.
The biggest caveat I see to holding debt is that it decreases your flexibility to deviate from your plan. If we knew we would be healthy and not have to leave our job for 30 years, then holding debt isn’t an issue. If you have health issues, want to retire early for other reasons, or just don’t want to be on the hook for monthly payments for 30 years, then paying debt off more aggressively has value—even if you end up with a lower net worth.
This all comes back to increased risk/ increased reward.
Debt is a risk. The math usually favors taking the risk. Until it doesn’t.
Also it does not take much to screw up a plan like this. I know very few people who will put every penny into their investments. Even if a small percentage gets spent along the way the benefit from the debt is negated.
I really enjoyed this read, though I think I still fit somewhere in the middle of the proposed models.
Also, the caveat at the beginning focuses on the psychology of “having debt” and how if your personality is debt averse, you should just pay off the debt.
I think that there are other behavioral finance or psychological reasons to pay off the debt.
1) Most people who pay minimum payments on debt do not use the money saved to invest. The mathematical argument only makes sense if the extra money you bring in actually gets invested. Far too often, people pay a minimum mortgage payment and when extra cash flow comes in, they just spend it to improve their lifestyle.
2) Automatic payments towards one endeavor or the other helps fix point number 1, but there is something to be said about being financially independent and without debt. Many don’t have a goal to be debt-free as early as possible, but do have a goal to be debt-free by the time that they retire early. If your mortgage pay off at 30 years coincides with retirement, then great! Personally, I have little interest in having mortgage debt when entering retirement at 50. This only increases mandatory payments during a time that you may need to dampen your withdrawal rate during a prolonged bear market.
3) Keeping debt around in physician circles can normalize debt a bit. I think aggressively paying down non-mortgage debt (while investing at the same time) is probably prudent to get rid of this mindset so that debt accumulation doesn’t continue or escalate.
4) I don’t think this is an either/or situation. A hybrid between the two where we pay down debt while investing is probably wise. Returns could be maximized mathematically, but math isn’t the only thing that matters.
Either way, this was a really interesting argument. I do think it is reasonable to approach this from either side (paying off the debt). I look forward to grabbing my popcorn this afternoon after work and reading through the comments on this one!
Good points and those were some of my thoughts as well for the masses. However, it’s worth considering WCI is a microcosm of physicians overall. Those on the FIRE path for the most part. So personally I think that as long as this article is focused towards those who have mastered the basics (strict spending control, moving all excess cash into investments regularly, controlling lifestyle inflation, etc.) then it’s a very valuable article for long term planning. Especially for anyone looking to buy a house in the middle of a bear market.
Can’t wait to see the comments on this one. The post, as your pointed out, PoF, is relying strictly on a mathematical calculation of a certain time period of low interest rates and high investment returns to show how compounding works. As Ramsey(who we all know has flaws in his own logic) and also WCI and others tell us, personal finance is about 80% personal/behavior and 20% finance/math. It sounds like this poster may trust in his excel spreadsheet 100%, but I think i’ll continue to invest while I pay down a 15 year mortgage and not leverage all of my investment accounts 10 years into a historically long bull market…
I love Warren Buffet’s Quote
“It always works until it doesn’t.
Borrowers then learn that credit is like oxygen. When either is abundant, its
presence goes unnoticed. When either is missing, that’s all that is noticed.
Even a short absence of credit can bring a company to its knees.”