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.
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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
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On what side do your preferences lie? Paying down debt or carrying debt and investing the difference? Why do you feel that way?