“There are only 3 ways a smart person can go broke; liquor, ladies, and leverage,” Charlie Munger once said. Dave Ramsey is also a big proponent of getting out of all debt as soon as possible and staying debt-free.
The average American spends more than what his income allows for, and doesn’t have much of savings/reitrement. As his income increases, his life style also soars proportionately, or at an even higher pace. This results in living paycheck-to-paycheck with no wiggle room. One hiccup throws a giant wrench in the mix and puts the family scrambling for options. In other words, most people are not financially responsible, and the maxim to avoid debts at all costs can serve well for a lot of households. Having said that, can we make a blanket statement that this is the best strategy for everyone?
Although being debt-free is better being buried in debt, there is an opportunity cost. Let’s say that the mortgage was 3.5%. By paying down this loan, we would essentially be getting 3.5% return. A S&P 500 index fund yields about 8-10% return, compounded.
Debt is like a double-edged sword. For those who are unassuming, it can be dangerous. High interest loans for consumer goods are best avoided in most cases. For those who are financially responsible and disciplined, leverage(especially low-interest loans) can be a powerful tool to accelerate one’s wealth.
It is my belief that using leverage and keeping low-interest loans does not necessarily forgo safety. There is an apparent misconception that becoming debt-free provides a higher-level of financial security. Let’s take a look at a hypothetical example.
Dave and Robert both makes $5,000/month. They both own $300,000 house with $240,000 loan, 3.5% interest, 30 year amortization. The monthly mortgage is $1,078, and monthly living expenses are $2,620. Both have $1,302 left over at the end of the month after paying the mortgage and living expenses. Dave decides to put the entire $1,302/month to paying down his mortgage. Robert decides to invest the $1,302 in a low-cost index fund that yields 9% return. After 10 years, Dave is able to pay down his mortgage and becomes debt-free. 0 mortgage! Robert still owes $185,825 and still makes the $1,078/month payments.
In savings, Dave has $0 because he put all his excess funds to paying down the mortgage. Robert, on the other hand, has amassed $252,012 with 9% returns from his funds. Both houses went up 3%/year and are now each worth $390,000. Dave’s net worth is $390,000 and Robert’s net worth is $456,188($390,000-$185,825+$252,012). Furthermore, let’s consider who would be in better shape if both individuals were to lose their jobs after 10 years. Although Dave has his house paid off and has no mortgage, he still has $2,620 of living expenses and has $0 in savings. Robert would have to pay the mortgage of $1,078 and living expense of $2620, for a total of $3,698. He also has $252,012 saved up. That’s over 5 years of living expenses. Based on the above example, one can see that Robert has a higher net worth and he is financially safer despite having a debt.
After 10 years, Dave will be able to invest more than Robert because he has no mortgage. Dave will be investing $2,380/month compared to Robert’s $1,302. However, since Dave is getting a 10 year late start, after 30 years, Robert will still come out ahead. Dave will end up with about $1.59M in savings and Robert will end up with $2.38M. By this time, Robert would’ve also paid off his mortgage.
| Dave | Robert | primary residence | stock market | |||||
| After 10 years | price | 300,000 | return | 9% | ||||
| mortgage balance | 0 | 185,825 | loan | 240,000 | ||||
| home value | 390,000 | 390,000 | years | 30 | ||||
| equity | 390,000 | 204,175 | rate | 3.50% | ||||
| savings | 0 | 252,012 | income | 5,000 | ||||
| total net worth | 390,000 | 456,188 | mortgage | 1,078 | ||||
| income | 5,000 | 5,000 | living expenses | 2,620 | ||||
| monthly expenses | 2,620 | 3,698 | surplus | 1,302 | ||||
| surplus | 2,380 | 1,302 | appreciation | 3% | ||||
| After 30 years | ||||||||
| mortgage balance | 0 | 0 | ||||||
| home value | 570,000 | 570,000 | ||||||
| equity | 570,000 | 570,000 | ||||||
| savings | 1,589,571 | 2,384,164 | ||||||
| total net worth | 2,159,571 | 2,954,164 | ||||||
| income | 0 | 0 |
Furthermore, if we assume that Robert buys an investment property with the money that he’s saved, the difference in net worth and financial health becomes even more pronounced. In this example, we assumed that Robert would buy a $500,000 4plex with $100,000 down payment and gets cashflow of $10,000/year(10% cash-on-cash return). This results in Robert’s income increasing by $833/month. When we factor in the additional income and the equity of the investment property, Robert’s net worth becomes $3.5M after 30 years whereas Dave’s net worth is $2.16M. If Robert buys two 4plexes, his net worth becomes $4.09M after 30 years. That’s almost double of Dave’s! Last, but not least, due to the cashflow generated by the 2 properties, Robert will actually have more surplus income at the end of the month compared to his debt-free friend, Dave.
| Dave | Robert | primary residence | stock market | |||||
| After 10 years | price | 300,000 | return | 9% | ||||
| mortgage balance | 0 | 185,825 | loan | 240,000 | ||||
| home value | 390,000 | 390,000 | years | 30 | ||||
| equity | 390,000 | 204,175 | rate | 3.50% | ||||
| savings | 0 | 252,012 | income | 5,000 | ||||
| Buys 4plex | mortgage | 1,078 | ||||||
| down payment | 0 | -100,000 | living expenses | 2,620 | ||||
| savings | 0 | 152,012 | surplus | 1,302 | ||||
| equity in 4plex | 0 | 100,000 | appreciation | 3% | ||||
| total net worth | 390,000 | 456,188 | ||||||
| monthly income | 5,000 | 5,000 | Investment property | in 20 years | ||||
| additional income | 0 | 833 | price | 500,000 | 800000 | |||
| monthly expenses | 2,620 | 3,698 | loan | 400,000 | 188,618 | |||
| surplus | 2,380 | 2,136 | years | 30 | ||||
| rate | 4% | |||||||
| After 30 years | cashflow (10%) | 10,000 | ||||||
| mortgage balance | 0 | 0 | equity | 100,000 | ||||
| home value | 570,000 | 570,000 | appreciation | 3% | ||||
| equity | 570,000 | 570,000 | ||||||
| 4plex equity | 0 | 611,382 | rents | 60,000 | ||||
| monthly income | 0 | 833 | expenses | 27,000 | ||||
| savings | 1,589,571 | 2,339,821 | mortgage | 22,916 | ||||
| total net worth | 2,159,571 | 3,521,204 | cashflow | 10,084 |
What’s counterintuitive is that Robert, who has a debt, seems to have more financial security than Dave, who is debt free. This is because the money that’s being given to the bank by Dave to pay down the loan is not accessible; it’s simply gone. The money that’s invested by Robert is accessible whenever he wants. In short, not only does Robert get much higher returns on his money by investing, he also has control/access to his money, unlike Dave. This gives Robert more of a financial safety net than Dave.
High interest debt poses a serious threat, no doubt. 20% interest credit card debt can be dangerous and spiral out of control. If there are high interest debts like credit cards, I would pay them off as soon as possible before saving and/or investing. If one has multiple loans with high interest rates, pay down the loan with highest interest first, or consider consolidating the loans and refinancing. If one has equity in primary residence, they can also consider doing a cash-out refi to pay off high interest debts.
But when it comes to low interest loans, it is not a problem if one has savings or other investments that they can readily access. That’s the crux of it. It’s not necessarily the debt itself that is dangerous; it’s the lack of financial savings that presents a risk.
I think that debts can be a great tool if the following criteria are met –
1. The individual has surplus after all living expenses
2. The loan is low-interest
3. It is for a cash-flowing asset
Conclusion – Paying off loans is not a bad strategy. But is it the best strategy? It’s worth questioning if getting out of all debts is relevant to everyone. The real danger to debt is being over-leveraged. If one doesn’t have enough savings and is over-leveraged, and/or has high credit card debts, he/she is walking on thin ice. High-interest consumer debts are best avoided. It’s also financially responsible to live below one’s means and set aside some money for retirement, savings, and emergency funds. Finally, with low interest loans, cash-flowing assets can be acquired. With these principles in place, it’s the author’s belief that debts can be a powerful tool to accelerate one’s wealth. Not only does investing generate higher returns than paying down a low-interest loan, it also provides additional safety because the owner will have access and control over the money while it grows.
This is for informational purposes only and does not constitute financial or legal advice of any sort. This article is the opinion of the author, and he does not guarantee any results. Always consult your accountant and lawyer.
By: Ki Lee