The Wrong Way to Think About Debt | White Coat Investor

By the time you read this, my family will have been completely debt-free for about three years.  From the time I was 18 until the time I was 42, we had some sort of debt, usually either a mortgage or even when renting we had the $5K student loan I took out as a college freshman.  We’re (fairly, in my opinion) ignoring the current month’s expenses placed on credit cards (always paid off automatically), the leverage used by limited partnerships/LLCs we invest in (since our loss is limited to our investment), and the leverage used by publicly traded companies whose stocks we own via index funds.  Everything we now buy, including our home renovation (the most expensive purchase of our lives), we buy with cash.  The White Coat Investor, LLC has never had any debt and we plan to continue to grow it debt-free.

That’s not to say I’ve never tried to use debt to our advantage.  All three of our homes we have bought with a mortgage.  My last year of residency we funded our Roth IRAs using a 0% credit card that we would pay off as an attending a few months later.  We pulled money from our accidental rental property in order to purchase our current home.  We drug out our final mortgage a couple of years longer than maybe we had to.  I say all that to point out that I’m far from innocent of the “financial sin” I’m going to describe today.  Let me explain.

I often suggest people pay off their debt or that they are over-leveraged in a blog post, on a forum, on social media, and even in real life.  While most agree with me, there is usually someone who pipes up to give some pushback.  The argument usually goes something like this: “It’s stupid to pay off a 2-4% debt because you expect your investments to do better than 2-4%.”  I used to believe this argument too.  It’s easy to do so because mathematically it is correct.  The older and wealthier I get, the more I see serious flaws in this argument, and I’d like to discuss them today because the argument is so darn common, even among people who are debt-free!

I’ve started pushing back on these people (and no, they don’t like it) by asking them two questions:

1. Are you rich yet?
2. If you are, did carrying debt at 2-4% while investing contribute to any significant portion of it?

The answer to number one is almost always no, but even if it isn’t, the answer to number two is also almost always no.  I fully acknowledge that there probably is somebody out there who would answer yes to both questions.  But they are surprisingly rare.  I run into so few of them that I’m not sure I can even describe them for you, but I postulate that most of them are real estate investors who maintain reasonable loan to value ratios of 50-66% on their rental properties.  The person advocating for more leverage is usually a 25-year-old with lots of debt, few assets, and little experience.  It never seems to be the 60-year-old multimillionaire I’d like to emulate.

 

14 Reasons You’re Thinking About Debt Wrong

Let’s list out some issues with this argument.  For purposes of our discussion today, let’s define the argument as “You should not pay off 2-4% debt any faster than you have to because the long-term expected return on your overall portfolio is higher than that.”  Now, let’s debunk it.

# 1 Justification

The majority of the folks advocating this approach are simply using it as justification.  “I’m not paying off that debt because I COULD invest at a higher rate.”  They aren’t actually doing it.  It’s a behavioral problem.  In fact, having many kinds of debt (auto, credit card, etc.) reflects a behavioral issue, not a difficulty in understanding math.  So the first thing I ask is “Are you actually investing the money that would go toward paying off that debt?”  Too often, the answer is no.  They are neither paying off their debts nor investing with that money–they’re spending it.

“I wouldn’t do that,” you say, but in reality, money is fungible.  If you are spending money on ANYTHING above and beyond the true necessities of life AND you have 2-4% debt, you are borrowing to fund that spending.  New pair of skis?  You borrowed to buy them.  Lift tickets?  Same.  A $15,000 car you paid cash for while you still have student loans and a mortgage?  They’re financed.  A meal out?  It’s just like you put it on a 3% credit card.  Now, maybe you’re fine using borrowed money for luxuries, but most people are not.  They view debt as either “good” (i.e. for a home or education or dependable car or an emergency) or “bad” (i.e. credit cards used to eat out and buy lift tickets).  Just because you have SOME investments and/or invest SOME money every month does not mean that you are taking ALL of the money you would use to pay down the debt and investing it.  Don’t let the fact that your interest rate is low lead you to justify excessive spending.

Now, do I expect you to live a spartan existence until your final student loan and then mortgage payment is made?  No, I don’t.  But every time you catch yourself not paying off your debts because the interest rate is low I want you to look around at everything you’re buying and ask yourself if you can justify borrowing at 3% to buy it.  I bet you’ll spend a lot less, get out of debt a lot faster, build more wealth, and have more freedom in your life.

# 2 You Are Ignoring Risk

Lots of people who make this argument simply look at two numbers and choose the higher one.  If the stock market has averaged 10% a year historically, and the student loan is at 4%, you don’t pay off the debt.  However, the reason long term stock returns are so much higher is because they are risky.  Without getting into a long, drawn-out philosophical discussion of what risk is, the fact remains that while the expected return on stocks might be 6-10%, there will be many years where the return is much lower.  It is not a guaranteed return.  Thus, you are comparing the guaranteed return available by paying off your debt to a non-guaranteed return available by investing.  That’s apples to oranges.  You must risk adjust the returns.  You must compare the riskiness of the investments.  Since debt paydown provides a guaranteed return, you should compare it to an investment that provides a guaranteed return, such as a Certificate of Deposit or Treasury bills.  What do those pay?  1-4% (and mostly 1%ish these days).  Exactly the same as paying off that low-interest debt of yours.

# 3 People Don’t Understand How Taxes and Debt Interact

Here’s another big issue.  Lots of people aren’t actually using the right numbers.  When you pay off a debt, you’re getting an after-tax rate of return equal to the interest rate of the debt.  When you invest, the return is generally subject to taxes.  You must tax-adjust both numbers before making a comparison.  Consider a doc with a 40% marginal tax rate earning 3% on a CD while carrying a non-deductible debt at 2%.  After-tax, paying off the debt gives you a return of 2%.  After-tax, that CD gives you a return of 1.8%.  That doc is looking kind of dumb now.

A similar issue comes up with regard to the deductibility of interest.  Many attendings are shocked to find out they can no longer deduct the $2,500 per year in student loan interest that they could deduct as a resident.  Sorry, that tax break isn’t available to high earners.

Likewise, many people think their mortgage is tax-deductible but then take the standard deduction.  Newsflash!  If you don’t itemize on Schedule A, neither your mortgage interest nor property taxes are deductions.  Since 2018 with the new, higher standard deduction ($12,400 Single and $24,800 Married Filing Jointly in 2020), a lot fewer people, even some high earners, are itemizing.  And even if you do itemize, it isn’t like that first $24,800 is actually deductible.  Really only the amount above and beyond that $24,800 is deductible and should be used to reduce your effective interest rate.

This all ignores what usually happens, of course.  Consider a high-earning doc who recently posted his situation on the Bogleheads forum.  He had an $80K 2.4% student loan and an 11.5 month emergency fund earning 1.6%.  It takes great amounts of tact to point out mistakes like that to otherwise very intelligent, high-earning people.

Tax advantages are also one of the reasons I am hesitant to tell people to pay extra on their low-interest rate 15-year mortgages or 5-year student loans before maxing out their retirement accounts.  Those advantages will often compound for decades.  But the point is that you need to understand how taxes affect your debts and your investments before you can really run the numbers on a mathematical decision.

# 4 Can’t Go Bankrupt Without Debt

I see people going through bankruptcy from time to time and it never looks like they are having much fun.  When we make these calculations and decisions to carry debt on purpose, we generally assume life going forward will be pretty hunky-dory.  We assume the present situation will carry on indefinitely.  However, that doesn’t always happen.  Divorce, disability, illness, death, COVID-19, drought, war, earthquakes, hurricanes, job loss, business failure, and all kinds of other financial catastrophes occur.  Some can be insured against and some cannot.  I am amazed how many financial gurus out there have gone bankrupt or been foreclosed on.  Maybe they learned their lesson and maybe they didn’t.  But if they didn’t, I certainly don’t want advice from them.  At any rate, without debt, you can’t go bankrupt.  It’s simply impossible.  Nor is there any point, since the point of bankruptcy is to restructure or wipe out some or all of your debts.  The likelihood of this happening to you is low, but it isn’t zero unless you’re debt-free.  You can be broke, but you can’t be bankrupt.

# 5 You Carry Too Much Cash

People with debt often carry more cash than people without debt.  Consider the classic 3-month emergency fund.  Let’s say your expenses are $10,000 a month, so you have a $30,000 emergency fund.  But your expenses include $800 in car payments, a $2,000 student loan payment, and a $2,200 mortgage payment.  Imagine, if you will, a life without payments.  Now, what are your mandatory expenses?  $10,000 – $800 – $2,000 – $2,200 = $5,000.  Now your emergency fund can be just $15,000 and you can invest the other $15,000.  Instead of making things complicated, just ask yourself “Would you rather earn interest or pay interest?”

# 6 Less Disability and Life Insurance

Not only do you get to lower your cash drag, but you can also lower your “insurance drag”.  Insurance is, on average, a money-losing proposition (insurance companies have expenses and want profit so the total payouts must be less than the total premiums paid).  Thus, you should not carry more than you really need.  As a rule of thumb, you need your disability insurance benefit to cover all of your expenses plus an additional amount for retirement savings.  The lower your expenses, the less disability insurance you need, and the lower the premiums.  Life insurance works similarly–if your mortgage is paid off, you need less life insurance to maintain the same lifestyle after the death of a breadwinner.

# 7 Use a More Aggressive Asset Allocation

People only have a certain amount of risk tolerance in their life.  If you use it all up on leverage risk, you are less likely to have any left over to use elsewhere.  Perhaps paying off your debt would allow you to tolerate a more aggressive asset allocation while still sleeping soundly at night.  The long term benefits of that are likely to overwhelm any potential arbitrage between your car loan interest rate and rate of return on a few thousand dollars.

# 8 Take More Risks at Work

Similarly, someone without debt hanging over their head can take more risks at work.  They feel more confident asking for a raise.  They feel more confident leaving the job (or just threatening to leave the job) for another.  They have more confidence telling an administrator “I’m not going to do that”.  They have more control over their job and enjoy it more and can thus stay at it for longer, earning the financial rewards of doing so.

# 9 Take More Risks with a Side Business

Being debt-free also allows one to take a lot more risk in business.  Entrepreneurs often talk about “runways”.  The idea behind a runway is to make it as long as possible to give “the plane” (i.e. the business) the greatest possible chance of getting off the ground before crashing into the forest at the end of the runway.  Debt, like investor money from venture capital, shortens runways.  A boot-strapped business that pays for itself as it goes along has an infinite runway.  It can just keep going for years without really getting off the ground.  I had a similar experience with The White Coat Investor.  It really took 4-5 years before I could justify the time I was putting into it instead of just seeing more patients.  Imagine if my family had needed that early WCI income to eat?  I would have had to close up shop long before the plane got off the ground.  Imagine how different your business decisions might be when there is a big debt payment to cover every month.  How might those decisions affect the long-term viability of the business?

# 10 Simplify, Simplify, Simplify

“The price of anything is the amount of life you exchange for it.”  These famous words from Thoreau can dramatically improve your financial life.  Trying to maximize your leverage does precisely the opposite.  Imagine how much time and energy is spent trying to shift around a dozen credit card debts, two auto loans, an RV loan, 17 student loans, and a couple of mortgages.  That is time that cannot be spent making money or even enjoying yourself.  One of my favorite things to ask someone who thinks using a 2% auto loan is a good idea is “Would you buy a garbage disposal on payments in order to invest?  If not, why not?  It’s the same thing.” How about a pack of gum?  Where do you draw the line?

Pay off your debt, simplify your life.  There’s a reason that those who do often describe a massive burden being lifted from their shoulders.  It is similar to the reason that so few people who become debt-free go back into debt.  That is always an option.  Just because you pay off your mortgage doesn’t mean you can’t go get another one if you don’t like being debt-free.

# 11 You Have to Care About Numbers That Don’t Matter

There are important numbers in personal finance:

• Net Worth
• Income
• Savings Rate
• Rate of Return
• Effective Tax Rate
• Marginal Tax Rate

But people who are in debt don’t seem to spend very much time on the most important numbers.  They seem much more concerned about other numbers that are, in the big picture, far less important.

• Credit Score
• Credit Limits
• Interest Rate
• Loan to Value Ratio

People without debt, or at least those with a solid plan to eliminate it, just don’t care about that stuff.  They solve problems in different ways.  For example, a few months ago we were trying to buy a bunch of books for the WCICON20 swag bags, but the transactions started getting declined.  It turned out the credit limit on the company credit card was just $20K (had been for years because we never had a need to increase it).  I was annoyed to have to call the credit card company to ask for an increase.  It shunted me into an automated menu. “How much profit did the business have in the last year?”, the computer asked.  I named a seven-figure amount.  It asked a few more questions and then told me it would get back to me in six weeks.  It was truly comical.  Even talking to a real person didn’t change things.

“Can I just write you a check to put on the card so we can finish these purchases?”

“Yes, you can do that.”

“So I can just transfer $100K to you today from the company bank account?”

“Oh no, we can’t take that. But you can pay off the $18K you have on there today with a transfer.”

It was a bizarre conversation.  But we did get the books ordered and presumably the credit limit will eventually be raised before it comes time to buy stuff for WCICON21.  Or we’ll just write a check.

# 12 The Spiritual Argument

Many of the most popular religions of the world have a very anti-debt stance.  Muslims don’t like borrowing or even earning interest and often seek out “shariah-compliant” mutual funds.  Jewish prophets condemned the charging of interest, at least to other Jewish people.  Christians hear scripture each Sunday such as:

• The wicked borrow and do not repay
• Suppose one of you wants to build a tower.  Won’t you first sit down and estimate the cost to see if you have enough money to complete it?
• The borrower is slave to the lender.

You may or may not care what a supreme being thinks about your decision to be in debt, but if you do, it’s one more reason not to keep it around any longer than you have to.

# 13 Liquidity is Overrated

I occasionally hear a similar argument, that I don’t want to pay off my debts in case something comes up.  “I want to be liquid.”  The thing about liquidity, though, is that you simply need “enough”.  More than enough doesn’t do you any good.  In reality, as you build wealth, a large portion of that wealth is likely to be quite liquid (ask yourself how many $100 bills you could stack on your kitchen table one week from now if you absolutely had to?), and the amount of liquid assets increases over time.  In fact, like most wealthy people, I have so much liquidity I am happy to give some of it up if I can be adequately compensated for doing so.  Retirees don’t need emergency funds.  Their entire nest egg is their emergency fund.  But even when you are just starting out, you define exactly how much liquidity you need.  It’s called an emergency fund.  Whether you decide you need one month of expenses or six, once you have that, the rest can be used to pay off debt without concern for illiquidity.

# 14 Multi-Millionaires Don’t Do This

If you want to do something difficult, it is generally wise to find someone who has done it, ask them how they did it, and copy them.  If you want to get rich, find some rich people, and ask them how they did it.  I do this all the time.  You know what they tell me?  They tell me the following were the keys:

1. Get enough education to get a high-paying job
2. Own your own job and/or start a business when possible to maximize your income
3. Save a large percentage of your income by being relatively frugal
4. Invest it in some reasonable way

That’s it.  They don’t say “get a cash back credit card and try to maximize it”.

They don’t say “buy a car using a 0% interest rate“.

They don’t say “swap your brokerage or bank account around frequently to score transfer bonuses”.

They don’t say “use airline miles for all your travel”.

They don’t say “drag your student loans and mortgage out for 30 years”.

In fact, as a general rule, when you ask them how they managed their debt they all paid it back much faster than average.  Sometimes they even feel a little guilty about doing so, saying “Maybe I could have done better if I had just invested that money instead of using it to wipe out debt”.  But you know what?  They probably couldn’t.  Because the same drive that causes someone to work hard, earn lots of money, save a ton of it, and invest it well also drives those people to pay off their debts quickly.  I feel the same way when I look back on the few times I tried to use debt to improve my financial situation.  In two situations, I used it to buy houses I shouldn’t have bought in the first place and lost money on both of them, at least after transaction costs.  Funding Roth IRAs with a credit card?  Didn’t move the needle.  The amount of money we made doing that is a rounding error.  Dragging out the mortgage for a couple extra years to arbitrage it?  Not even 0.1% of my net worth.  Do yourself a favor–focus on what really matters and don’t get distracted by gimmicks like I did.

Taking on debt to invest sounds so intelligent, even if it doesn’t feel right.  If you find yourself wanting to pay down debt, but feeling stupid about doing so, I would encourage you to read the infamous 2008 Market Timer Thread, where an incredibly intelligent person decided to “mortgage his retirement”.  The outcome, in retrospect, was not terribly surprising, but to read about the experience as it unfolds in real-time is enlightening.  The most impressive thing is how smart he sounded…until he didn’t.

The Best Way to Use Leverage

Now, after 3200 words, it’s time to get on to the point of this entire blog post.  If, despite the above diatribe, you have decided you need or want to add leverage risk to your life to help you reach your financial goals a little faster, this is how I think you should do it.

Don’t ask yourself, “Can I earn a higher rate of return than I am paying in interest on this purchase?” with every single little purchase you make.  This is the way most people do it and what I would call the wrong way to think about debt.  I think you should ask yourself “What is the correct amount of leverage I should have in my life?” (i.e. the right way to think about debt) and then make adjustments as needed to maintain that level of leverage.  Obviously, you want the terms on any loans you do have to be as good as possible (a 25% credit card loan or a payday loan is pretty much always bad), but really the key is the amount of leverage.  Where does this leverage come from?  It can come from mortgages, low-interest-rate student loans, a 0% car loan, the IRS, or even margin loans against your portfolio.  The idea is to avoid “oppressive debt” while taking advantage of debt with favorable interest rates, terms, and tax advantages.  But most importantly, to have the proper amount of debt.

So how much is the correct amount of leverage?  Well, if you ask the guy who wrote the book on it (The Value of Debt by Thomas Anderson), the proper amount is between 15% and 35% of your assets.  So if you have $1 Million in assets, the amount of debt to maintain is $150-350K.  So if you have a $5 Million portfolio, carrying around $1 Million in debt might boost your returns a bit.  Less than 15%, you’re not going to move the needle and you might as well pay it off.  More than 35%, you’re taking on too much risk.  I almost never run into docs whose debt ratio is between those numbers.  Usually, it is dramatically higher.

Consider a dentist who just came out of dental school ($500K in student loans), bought a house ($500K doctor mortgage) and a practice ($500K practice loan).  Maybe she has $1M in assets between the house and practice.  What’s her ratio?  150%.  About 5 times the maximum recommended debt.  Even Anderson, perhaps the biggest debtophiliac out there, thinks she needs to get a big chunk of that debt paid off ASAP.  In fact, he thinks that most people really can’t handle any debt safely.  But if you’re going to do so, I think this is the approach to take.

So the next time you have someone tell you to carry your debt around in order to invest, ask them “Did it work for you? Is that why you’re a financially independent multi-millionaire?”  I’ll bet they don’t like those questions and I’ll bet the answer to both of them is no.

What do you think?  Are you incorporating a defined amount of leverage into your financial plan?  Are you guilty of justifying your debt due to low-interest rates?  How do you think about debt?  What’s your debt ratio (debt/assets)?  Comment below!