We hope you had a great holiday weekend and a very Merry Christmas! If you are looking for the fourth installment of the Safe Withdrawal Rate series (see part 1, part 2, part 3), please come back next week. Who is in the mood for heavy-duty number-crunching when we’re still digesting the heavy meals and scores of eggnog from last weekend? Yup, every year around this time we reconfirm the concept known as “too much of a good thing.” Only those of you free of the sin of overconsumption can throw the first meatball, uhm, stone. I’m waiting… Still waiting… Nobody? See, we’ve all experienced overconsumption between Thanksgiving and Christmas. But is the opposite true as well?
Can there be too little of a bad thing?
The bad thing I’m talking about is debt. To many of us in the FIRE community, debt is a four-letter word – figuratively! An entire niche of the Personal Finance blogging world is dedicated to getting out of debt and that’s a really good cause especially for those with a low or negative net worth. Paying off credit card debt at 18-20% or student loan debt with high single-digit percent interest rates should be priority number one. But that doesn’t mean that all debt is bad. For us in the ERN household, we’re blessed to never have had any sizable debt, except for a 30-year mortgage that we plan to pay off not a day earlier than we have to. We enjoy the ultra-low interest rate (3.25%), the tax-deductibility and putting our money to work with higher expected returns elsewhere. We love Leverage!
So, in general, we agree that too much debt is bad, but not all bad things are created equal:
Exhibit A: Bad things that are unsafe in any quantity
It’s my understanding (as a non-medical professional) that cigarettes are bad for you, regardless of the quantity. So are a lot of illicit drugs. We completely agree that some bad things should be avoided at all costs and all the time. But we doubt that debt is one of them!
Exhibit B: Bad things that are good for you in small quantities
Alcohol is a dangerous nerve poison that will impact your cognitive abilities in tiny doses, impact your driving at a blood alcohol concentration (BAC) of only about 0.05% and likely kill you at a BAC of around 0.5%. Continuous overconsumption could cause heart disease, fry your liver and mess with your brain to name just a few negative side-effects.
But alcohol consumed in moderation actually has some health benefits. Red wine contains substances with unappetizing names (antioxidants, polyphenols, resveratrol) but they are actually really good for you, see here for the 8 reasons to love red wine. But researchers found that even the alcohol itself (!) seems to support your health (see here). Heck, our blogging friend Physician on FIRE recently gave away beer for charity, so ethanol can’t be that bad. The man is an anesthesiologist after all!
What means moderation? About one to two drinks a day seems to be the generally accepted quantity that’s not just safe but even supportive of health and longevity (see Mayo Clinic link), not to mention our quality of life. They didn’t mention that we can safely double the alcohol intake if we live in France, Italy, Spain or Portugal and consume red wine with every meal. But I’m sure I read that somewhere, too.
Debt/leverage: Is it like alcohol or cigarettes?
All right, what is debt then? More like a cigarette to be avoided at all cost or more like alcohol with benefits if applied in moderation? Dave Ramsey and Suze Orman seem to think that debt is like a pack of Marlboro Reds or, even worse, those awful Gitanes with the yellowish paper and no filter. Unhealthy in any quantity, probably unhealthy to even look at!
But have we gone too far in the quest to eradicate debt? Here is some food for thought, seven reasons why we believe that debt and leverage in moderation can be good for us, just like the occasional beer or red wine:
1: The most successful investors use leverage to boost returns
Granted, the most colossal failures in business were bankrupted by too much leverage (LTCM, Lehman Brothers, etc.). But that doesn’t mean that successful investors should all use zero debt. Look at real estate investors: whether it’s REITs, or private equity real estate deals, nobody could be successful in today’s competitive landscape without at least a moderate degree of leverage. Or more broadly, most corporations have sizable debt. If operating debt-free was such a superior business practice we should have already seen the emergence of “Big-Debt-Free, Inc.” driving all the existing leveraged corporations out of business and taking over the world. Competitive forces work swiftly in the business world! The fact that we haven’t seen the competitive pressure to eradicate debt implies that moderate leverage can’t be all that bad. Just like one beer a day supports your heart health!
All of our investments use leverage. We invested in real estate through several Private Equity funds that buy and/or develop multi-family housing. They all use leverage to juice up returns. In fact, without leverage, the projected net returns wouldn’t attract any investors. Or another example: our 3x leverage put writing strategy we have been running for a number years already. There isn’t really explicit debt involved because futures and futures options all trade on margin, but economically it’s equivalent to getting a loan at the rate of overnight cash and levering up this baby 3x! So wherever you look in finance there’s leverage and it’s not all bad.
2: Debt is useful in smoothing out investment cash flows
We face this dilemma all the time. An investment opportunity emerges or we get a capital call from a private equity fund to transfer a pretty substantial sum within one week. Where do we get the money? The next bonus payment is a few months way. We could sell some investments, but then we’d incur capital gains. Even if they are long-term gains we’d prefer to defer them until they are taxed at a lower rate (or zero) in retirement. So, we simply borrow the money, short-term, until the next bonus season. The HELOC charges about 4% p.a. and Interactive Brokers charges about 2% p.a. in our margin account. For a few weeks or months, the interest cost is a rounding error compared to the fat tax bill.
3: Leverage can potentially make investments less risky
Huh? How is that possible? Leverage makes all investments riskier all the time, right? That depends on the nature of the risk. Aggregate vs. Idiosyncratic. Would I rather invest in three real estate properties all paid in cash or 10 properties each with a 70% mortgage? If I can spread around the idiosyncratic risk of vacancies, major repairs, mold problems, hurricanes, earthquakes, lawsuits, etc. over a larger number of properties and over a wider geographic area, I’m all for it! Additionally, talking about lawsuits, as we pointed out before, a mortgage on a property could serve as a poison pill against greedy lawyers trying to sue you and a put option on the property value in case of idiosyncratic catastrophic losses. If used in moderation debt can reduce risk, too.
4: Paying off a mortgage early compounds your “sequence of return risk”
Another favorite pastime in the finance community: Paying off the mortgage way ahead of time. Here’s one reason why that’s a bad idea: Sequence of Return Risk. What does a mortgage have to do with sequence of return risk, something normally associated with the withdrawal phase in retirement? Low returns early on and high returns later will be worse for your retirement sustainability than high returns early on and low returns later. The opposite is true during the accumulation phase. All else equal, you’d strongly prefer low returns early on and high returns later while steadily saving every month. The timing of high versus low return adds risk to your IRR during the accumulation phase.
So, let’s look at two friends Adam and Betsy. Both have a $200,000, 30-year mortgage at 4% interest.
- Adam scrapes together every last penny every month and pays $2,094.90 per month instead of the required mortgage payment of $954.83. Doing so he can pay off the mortgage in 10 years and save a ton of money on interest. He can also start saving the entire $2,094.90 every month starting in year 11. Suze Orman would be proud of him!
- Betsy pays only the required $954.83 every month and saves $1,070.07 in an equity index fund.
After 30 years, of course, Betsy comes out ahead significantly, by more than 20%, even assuming a modest 7% (nominal) equity return (even assuming zero advantage from the mortgage interest deductibility). We knew that. But: because Betsy spread out her investments more evenly over the 30 years she is less subject to the dreaded sequence of return risk. Higher return and lower risk. All thanks to not paying down the mortgage faster than necessary!
5: Debt is useful as an emergency fund
OK, we can already foresee the angry comments, but please hear us out. The idea goes as follows: Would you rather have an emergency fund invested in cash (current yield maybe 1%) and forego an expected equity expected return of, let’s say, 7% or keep your investments in productive assets and use debt to finance the occasional emergency? The emergency fund is a constant drag of 6% p.a. (=expected equity over cash return). If emergencies come about with a low enough probability (say 10%) then even paying a substantial interest rate on the emergency debt should beat the permanent emergency fund.
Even a credit card balance at 18-20% annual interest, if used only 10% of the time, easily beats the permanent emergency fund: 0.1 x 20%=2% < 6% =1.0 x 6%. But debt doesn’t even have to be that expensive: We’re talking about 4% interest on a home equity line of credit (HELOC), which we use as our emergency fund. Even if you don’t own a home, banks offer reasonably priced lines of credit as pointed out in this excellent post the other day to be used in cases of short-term cash flow needs. Of course, all of this requires responsible use of debt. If you face one emergency after the other and you constantly have to tap your emergency fund then please don’t go into debt. But, as we have written before, a lot of home and car repairs and maintenance expenses are not really emergencies, they should be budget items. If we may quote ourselves “Something breaking down is not an emergency. Something breaking down earlier than expected is an emergency.”
6: Debt is an inflation hedge
For folks who are concerned about the loss of purchasing power, there is almost no better way to hedge against inflation than having nominal debt, ideally with a fixed interest rate. We currently have a mortgage with a $500k+ balance and the thought of 2% inflation p.a. chipping away at our mortgage balance to the tune of over $10,000 a year gives us a warm and fuzzy feeling. And that’s before Papa ERN pours the Single Malt Scotch (in moderation, naturally).
OK, we can already hear the objections: Of course, the $500K+ in additional investments we now own because we didn’t pay down the mortgage also melt away due to 2% inflation. True, but our investments are in equities and real estate. Corporate profits, rental income, and real estate values will eventually catch up with inflation. The decline in the purchasing power of the mortgage balance that our lender suffers, on the other hand, is permanent.
7: Sometimes Cash is King, but …
Sometimes cash is king, of course. If you bid on a property at a foreclosure auction you better have a cashier’s check with you. Most of the time, sellers prefer buyers with a cash offer: it removes one additional uncertainty because buyers with a mortgage could still lose their funding in the last minute and cause the deal to fall through. Jon Dulin at MoneySmartGuides saved a ton of money when he used his cash on hand as a bargaining chip in negotiating a lower price with a seller. Of course, that still doesn’t mean you should avoid debt at all costs and all the time. One could pay cash to close the transaction quickly with the seller but then get a mortgage afterward. And then use the proceeds of the mortgage for the next transaction. Juice up returns (see #1) and spread the idiosyncratic risk over more properties (see #3)!
Love it, ERN! And many thanks for the great shout!!
I agree in full…can’t really add anything here… I’ll just make a complementary point that, in corporate finance, the fastest way to 1) increase enterprise value (analogous to increasing household total wealth) and 2) reduce takeover risk (roughly analogous to reducing household lawsuit loss risk) is by levering up that balance sheet – adding debt!
As you rightly point out, ain’t no Debt Free, Inc.’s out there driving the levered guys out of business…in fact, it’s the other way around. As a prospective shareholder in a company, you (ought to) demand something at least close to the optimal capital structure (i.e., with a good chunk of debt) to ensure adequate free cash flows to equity. If you demand that kind of balance sheet activity by the companies you’re likely to invest in, you ought to do the same on your own balance sheet.
Brilliant stuff as always, and a fun read. Now where’s this fraternity party I’ve been hearing so much about?!
Awesome! Thanks for stopping by! Yes, that corporate America argument was obviously inspired by your post and my comment there. Thanks for providing more color on that topic. Never thought about it that way, but it makes perfect sense that a cash-rich company without debt would be the perfect takeover target. Great point!
Cheers!
So glad I discovered this post. I was always surprised that people are worried about inflation eating up their nest egg. My calculation is this: I always want to have mortgages or other loans (invested in cashflowing assets of course) that are in sum higher than the portion of my assets that is subject to inflation (cash, CDs, bonds, P2P lending, fixed income instruments etc.). For all other assets (equities, physical real estate, REITs) inflation doesn’t hurt me, because they move more or less with inflation. For cash, CDs, bonds, P2P lending, etc. inflation will decrease the real value of these assets, but the real value of my debt decreases at the same rate. Which means if my mortgage debt is higher than my cash, CDs, bonds, P2P lending, etc., I am actually making money the higher the inflation rate is. Did I miss anything?
Yes, sure, you got the idea. But make sure you’re not holding too much dead-weight low-interest fixed income. That would have a “negative carry” if the interest rate is lower than the mortgage: https://earlyretirementnow.com/2016/11/02/why-would-anyone-have-a-mortgage-and-a-bond-portfolio/
Two key tenements within my “conservative” plan has been to enter into FIRE with: #1) a fully invested nut that I could pull 3.25-3.50% SWR from, and #2) above-and-beyond, a fully paid-off home in our new LCOL area.
My key reasoning for #2 above, had been to minimize monthly expenses, adding further safety cushion between our normal expenses and the SWR cited above. Most likely path would be to rent for the initial 1-2 years in new LCOL area, followed by purchasing if/when the right home was found.
The way I interpret this (and other work you’ve done), is that holding a modest loan would 1) assist with sequence of return risk, 2) act as a “bond like” portfolio allocation, 3) keep larger % of net worth liquid to capitalize on other potential opportunities. Is that a fair summary?
If so, assuming my future mortgage debt was in the neighborhood of 10-15% of overall net worth, does that seem like an appropriate ballpark to accomplish the 3 interpreted points above?
Thinking this through … thanks again, ERN.
Quick clarification: The Sequence of Return Risk (SoRR) example was meant for someone in the accumulation phase (as I am right now).
In the withdrawal phase, one could argue that having a mortgage increases your SoRR: You have to withdraw money to pay the mortgage even if the market is down. So a mortgage is no bond substitute, quite the opposite: You’re shorting a bond.
What we want to do in retirement is probably close to your plan: Maybe rent initially, test the waters in the new location, then buy later. Depending on how much of an appetite we have to “short a bond” at that time we might get a mortgage too. 🙂
Cheers!
GREAT clarification. We are also in the accumulation phase home-stretch, and carry a mortgage with no intentions of paying it off early. I tried testing the math for a mortgage during the withdrawal phase (possibly on a napkin) after leaving my comment with you earlier, and couldn’t make sense of it. Your explanation is helpful.
Thanks! Glad you liked it. Good luck on the FIRE home-stretch!
Cheers!
I completely agree. I don’t get peoples aversion to debt. Of course there is bad debt, but using good debt as leverage is an important tool. I was just working on a post about what kind of debt I like to keep, I wouldn’t be FIREd without it🙂
Awesome, glad we agree on that one. Looking forward to your post. True, some of my best investments were made possible by debt. For example paying only the minimum payment on my mortgage and plowing everything else into the stock market in 2009!
Cheers,
ERN
I have mixed feelings on the debt as an emergency fund option. The real reason would be the risk of the issuers default. If both you and them struggle things might get ugly. I’m not above using it in conjunction with other options. I also agree that debt is the best hedge against inflation provided its fixed. That being said I still somewhat pay ahead on my mortgage. Sometimes it’s a psychological thing not a total return question. I’m not taking money out of savings to put on my mortgage, or not maxing out tax advantaged accounts. But I do throw a bit extra on my mortgage from time to time in the hopes of having it gone in another ten years. If it psychologically keeps me full steam ahead investing in a down market then it’s done it’s job.
Can’t argue with feelings! If it makes people sleep better, paying off the mortgage faster is probably a good investment. It took me some effort to stop worrying about the mortgage. 🙂
Thanks for sharing!
I get the sense that many folks equate debt to the cigarettes level of bad, but I agree with you! I wouldn’t be where I am without the use of leverage and I have to assume it’s because I watched my parents have a mortgage and it just seemed like a pretty normal expense to have around.
Haha, yes, a mortgage is definitely not the cigarette-style of bad. Just like you, the mortgage afforded me to have lots of extra cash left over to invest steadily throughout the global financial crisis and pick up some nice bargains!
Thanks for stopping by and all your Twitter shout-outs!!!
Cheers,
ERN
Another great post! First day in my Corporate Finance class during my MBA program to oversimplify…always push your expenses out in time for a higher NPV. Let inflation naturally do its magic!
Great comparison to cigarettes and Alchol. Like any investment you need to educate yourself and be responsible. Most people get in trouble with Mortgages because they listen to they guy making the loan on how much the can afford and put themselves in financial distress.
My biggest pet peeve when certain financial blogs talk about how renting is so much better than owning is they don’t take inflation into account. Rent is going to increase over 30 years, your 30 year fixed mortgage payment is not.
I would just add a caveat to this analysis that it works best if you buy and hold your primary residence for the long term. I just shake my head at people that move every couple of years because you are just making the title companies and real estate agents rich paying for all those closing costs and sales commissions every few years.
Thanks for adding color to the corporate debt issue. Good to know that the Corporate Finance experts agree with me on this!
Also: great point. home-ownership is a great inflation hedge, especially against rising inflation, both from decay in the real mortgage balance and the hedge against rental inflation. If one can keep the transaction costs low (i.e., buy a house and stay there for the long-haul). Thanks for sharing!!!
Great post, ERN, very thorough! I’m definitely with you in that there is good debt and bad debt. When used appropriately debt can be great for wealth accumulation, can’t argue with the numbers.
We use debt in the form of low interest mortgage and car loans and also as small business owners we use moderate leverage to maximize our returns.
And now that I know a beer in moderation isn’t bad either, cheers to good debt!
Thanks TGS! That’s exactly the spirit (pardon the pun) to enjoy booze and debt in moderation for maximum returns and happiness. Happy New Year!
Happy new year!
Good post ERN. No quibble on the numbers but the argument against leverage is something beyond just low interest rates and opportunity cost of excess capital. There are other factors at play, including property taxes, repairs and other ‘drags’ that renters don’t have, not to mention the opportunity cost of the down payment itself invested in the same equity index fund that you use to make the case for a 30 year mortgage payment example. I also talk about career cost in one of my articles as another factor in favor of rent vs buy decision, but that’s beyond the scope here. Overall, the broader advice against leverage is a good thing in my opinion. Few have the discipline to do years of investing the ‘prepayment excess’ into index fund, but a prepayment on a mortgage serves as a “forced” savings and easier to grapple with as a concept for most. You and FL are in a different league of smart leverage users, so this makes sense.
Thanks, TFR! Yes, all the caveats about home-ownership apply as you brilliantly pointed out. Also, as we calculated earlier, the rental yield has to pretty high for homeownership to be economical. But once we own a house and have suffered that sunk cost already, we might as well use the leverage.
Cheers and Happy New Year!
Good debt was good when I had it, and I wouldn’t be afraid of taking some on again someday.
But… being debt free is a great feeling. I know I would come out ahead most years with a little mortgage leverage, but being 100% mortgage and debt free gives me peace of mind that’s hard to put a price on.
Thanks for the mention, by the way. I’ll buy you a beer one of these days… maybe even with my own money.
Oh, and Happy New Year!
-PoF
Yeah, can’t argue with that comfort of being debt-free. In retirement, I might also go debt-free for peace of mind. Who needs more equity risk when you already face the dreaded Sequence of Return Risk? But while working, I have always felt confident enough to lever up and juice up returns.
Yup, let’s have a beer one of these days. I will pay the second round! 🙂
Have a Happy and prosperous New Year, Dr. PoF!!!
ERN
Leverage is sensible when used to buy a fairly stable asset with expected returns greater than the cost of debt (e.g., commercial rental property) and I like your example of using leverage to expand your asset base to achieve diversification (and perhaps reduce net risk).
On the other hand, if you sell puts without the cash to cover them you may do well, but you’re courting financial ruin. Stocks can fall a long way for a long time (see Japan).
You’re aware of the current PE10. The next bear market may bottom at a single-digit CAPE and last for years. I don’t agree with everything John Hussman writes (mainly the market-timing material), but his 12-year return estimates are reasonable: http://hussmanfunds.com/wmc/wmc161219.htm. He describes a base-case scenario here. Actual outcomes may be much worse.
Thanks for the reply!
The 3x leverage put option strategy is not as risky as it seems. The drop in Japan happened over several years. I sell puts weekly, sometimes even sub-weekly (Friday to Wednesday, then Wednesday to Friday). If there is a drop one week, volatiliy goes up and consequent weeks will offer much richer premiums and strike prices very far out of the money (2008/9 for example).
Also, since we sell the puts out of the money it would take a substantial drop for the 3x leverage to kick in, as we wrote in that post:
Cheers and Happy New Year!
ERN
Lots of great points ERN. if the person knows all the numbers, can manage the debt, has dependable income etc then it definitely comes ahead in all areas.
Slightly different scenario in Australia where the mortgage isn’t deductible in the house you live and you can earn (currently) 3% on cash in the bank – so more people go for that.
POF also makes a good point have having the peace of mind.
We will take on debt for our own home and probably won’t try to pay it off any quicker (depending on the interest rate) and we’d have debt for any investment properties we buy. We are comfortable having cash at this point though 🙂
Tristan
Tax deductibility makes a huge difference. After retirement that tax write-off goes away for us and we, too, might decide to live mortgage-free. That’s still up in the air. There is some benefit to living debt-free, for sure. Let’s see how adventurous we are come retirement. 🙂
I’m firmly in the not all debt is evil. I understand some feel very strongly about it being bad, but I’ll just have to respectfully disagree. I have had bouts in my life of very poor use of debt, but in the last 10 years or so, I’ve done great things with other people’s money. I’m currently not paying down our mortgage to fully fund every last bit of tax-deferred accounts we can get into. I’m also paying into my kid’s 529 plans so they can avoid bad debt in the future. I don’t have any problems sleeping at night knowing the bank has graciously loaned me over $100k at under 3% interest while I use their money to invest in my retirement and my kids’ educations.
And I agree about using debt as an emergency fund. Not all of our emergency money is “credit”, but about 50% of it is. I see it as an insurance policy, the deductible of which is the interest rate. If I have to use it, there will be a cost. I am okay with that.
GREAT article. Loving your stuff.
Thanks Jeff! Glad we’re on the same page.Thanks for sharing your experience. Essentially the same philosophy as ours…
Cheers!
I certainly don’t feel debt is evil, but I’ve chosen to live completely debt-free. During the downturn of 2008/2009, I watched my high-earning company I owned crumble as well as my net worth drop nearly in half. I was logical, and bought more equities as the market plummeted, but I also suffered serious anxiety and sleepless nights. What kept me awake was my “monthly nugget”, of which the vast majority were required expenses like my mortgage, car payment, utilities, etc. It provided little comfort to know that my mortgage rate was low and the interest was tax-deductible. Now, my equity allocation is much lower, I’m completely debt-free, and I sleep better. For those who can handle the emotional roller-coaster, or who are still in the active accumulation phase and plan to work for a long time, I agree some leverage can be helpful. But I suggest everyone literally do a gut check (how did you gut feel last time there was a huge market swoon?) before deciding to lever their returns. BTW…I just discovered this site today after someone mentioned it on early-retirement.org and I love it! The authors are obviously whip smart, funny and committed to doing interesting and relevant research. Keep it up!!
Great point. Peace of mind is priceless. If folks have trouble sleeping with too much debt, don’t risk it. But I sleep very well, so I can take that calculated risk.
Thanks for offering your perspective! Greatly appreciated!!!
Way to mention LTCM…haven’t heard that name in years! You and I are old school, ERN!
Yes, we are. And we are still looking good for our age, don’t we? Going trough that period, Mexican crisis, Asian crisis, Russian default, LTCM, etc. definitely helps put things into perspective.
Cheers!
I generally go back and forth on this issue. I tend to start paying off the mortgage the more and more I feel like equities get overvalued. After the late 2016 and early 2017 run-up in equities, I’m not selling to hold cash by any means, but I feel like it can’t be *that* bad to slow contributions and move payments to my mortgage. When the mortgage is paid off, hopefully the valuations will be better and I can make much larger contributions with the former mortgage payment money.
I see you also have some thoughts about the current CAPE and equity valuations. It seems to me hard to believe strongly in both ideas at the same time (high valuation, leveraged equity investments). What are you thoughts on the interplay of the two?
Sorry I’m late to the party on this post, just came across it today…
Excellent question. And a very timely one, too! I want to distinguish between
1) the equity return outlook itself, which is not that great given the high CAPE ratio, hence all of our writings on safe withdrawal rates, etc.
2) equity vs. bond return outlook: Compared to bond returns, equities still look decent. Especially compared to a 3.25% mortgage that has a negative real return (our 40%+ marginal tax brings the effective mortgage rate to less than 2% = my inflation forecast).
So the distinction between 1+2 explains why I’m cautious about equities but still not pay down our mortgage. Hope this helps! 🙂
Cheers,
ERN
Sure, that makes much more sense now, thanks. I guess you probably think i’m a bit crazy even having this debate with a 2.1% mortgage then! (I’m in Canada, it’s easier to get lower rates here I gather)
Wow, that’s a low interest rate! But as far as I know, mortgage interest is not deductible in Canada, right? So your after-tax rate is not very different from mine. Why not buy some low-volatility dividend stocks and let them pay the mortgage? 🙂
Anyway, thanks for sharing!
I should say, that rate is variable though, so not quite as predictable. Been great for the last decade + but eventually it will go up.
Rates could be on the rise, true. But it’s going to be a sloooowwwww pace. I’m not too worried. 🙂
I enjoyed your article and have recently discovered your site. I agree with your points about good debt such as mortgage. I saw the responses from Financial Libre and miss his site. To FL’s point and yours, how does one arrive at determining an appropriate percentage of debt relative to total net worth, from FL’s comment Dec 28, 2016:
“As you rightly point out, ain’t no Debt Free, Inc.’s out there driving the levered guys out of business…in fact, it’s the other way around. As a prospective shareholder in a company, you (ought to) demand something at least close to the optimal capital structure (i.e., with a good chunk of debt) to ensure adequate free cash flows to equity. If you demand that kind of balance sheet activity by the companies you’re likely to invest in, you ought to do the same on your own balance sheet.”
Yeah, I wonder what happened to FinanciaLibre! The URL now goes to an online shoe retailer in the U.K., go figure!
It’s hard to look for an optimal capital structure for households. As I wrote in the SWR series Part 21, in retirement you’ll be better off without a mortgage due to net withdrawals from the portfolio. When still working, leverage is great! Early in my career, I benefited from being as leveraged as banks were willing to fund me, i.e., have the largest possible mortgage and pump everything else into the stock market. That doesn’t mean one should buy the largest possible house. Quite the opposite, buy the smallest possible house to lead a happy, yet frugal lifestyle, but on that house get the maximum mortgage, never make additional payments until a few years before retirement when you like to raise the bond allocation.
So glad I discovered this post. I was always surprised that people are worried about inflation eating up their nest egg. My calculation is this: I always want to have mortgages or other loans (invested in cashflowing assets of course) that are in sum higher than the portion of my assets that is subject to inflation (cash, CDs, bonds, P2P lending, fixed income instruments etc.). For all other assets (equities, physical real estate, REITs) inflation doesn’t hurt me, because they move more or less with inflation. For cash, CDs, bonds, P2P lending, etc. inflation will decrease the real value of these assets, but the real value of my debt decreases at the same rate. Which means if my mortgage debt is higher than my cash, CDs, bonds, P2P lending, etc., I am actually making money the higher the inflation rate is. Did I miss anything?
Replied above already:
Yes, sure, you got the idea. But make sure you’re not holding too much dead-weight low-interest fixed income. That would have a “negative carry” if the interest rate is lower than the mortgage: https://earlyretirementnow.com/2016/11/02/why-would-anyone-have-a-mortgage-and-a-bond-portfolio/
We should leverage everything we can as long as it makes sense and we take different risks in to consideration.
If you can buy an asset that you are comfortable will generate a significantly higher cash-flow, why not use it. The challenge might be if you can not use your home as collateral but an equity portfolio (even with low interest), there might of course be margin calls and it might sting if you don’t have the cash..
I love using leverage and try to use it wisely, in particular when it comes to money the other two favorite areas is to leverage my time (using other peoples time) as well as other peoples knowledge.
Currently one of my best sources of leveraging knowledge is by learning from YOU! You have spent years on this and sharing this with us here is so cool, it is absolutely fantastic that we can take part, learn from you and we don’t have to spend a decade coming to the same conclusion:). Amazing and thankful!
Lets use as much leverage as we can to propel our lives in every area but learn from the best so we don’t have to repeat mistakes someone else has already done.
Again, a big thank your for all your brilliant posts!
Jakob
Very nice! If used in moderation, leverage can be a great tool. But the key is to find where the sweet spot is, which depends on the average return and the magnitude of the black swan event.
The optionsellers.com debacle is a cautionary tale of how people got it wrong. I’m planning an upcoming post on that topic. 🙂
Regarding #4: would your advice still apply if I can pay off my 4% mortgage in 2.5 years, then investing the difference for retirement in 8+ years later?
Depends. If you are retired, sure, why not. If you plan to retire in 3 years: absolutely, you want to pay down the mortgage.
If you plan to retire in 10+ years, I’d still draw out the mortgage as long as possible and get more dollar cost averaging in my stock investments.
Hello ERM,
I am already retired but I still carry a 130k mortgage. I have the opportunity to put 70k down on my mortgage for my renewal next month. My interest rate is 1.92.
My expenses and income in retirement are fairly equal, leaving me with not a lot of wiggle room.
However, cutting my mortgage payments in half with the 70k deposit would reduce my monthly expenses. But would it be put to better use in the stock market?
Living on a fixed income, my thoughts are that I would want to reduce my exposure to the risk of an upcoming bear market by putting the money down on my debt.
(Also I can’t help but consider the economic unpredictability of COVID)
What would you recommend I do with my 70k in savings?
Thank you!
The way a partial mortgage prepayment works is that normally your payments stay the same, you simply reduce how long you will repay the mortgage. So paying down the mortgage is almost the worst of both worlds: your current tight cash flow situation doesn’t improve until several years into retirement. But you lose the cheap leverage.
There are some mortgage companies that allow you to recast/recalibrate the mortgage, where if you pay down half the mortgage you keep the same mortgage term but cut your future payments in half. I’d first check with the mortgage servicer if that’s an option for you.
That’s true. With the 70k payment my mortgage is so small that I re-did it into a 5 year term. Essentially the same payments but in 5 years it will be paid off.
Still, is it better to invest it?
I’m reading a lot of advice that says it’s better to carry a mortgage and throw all your extra $ into investments to capitalize on time value of money. Is it too late for me to take advantage of that since I’m already 65 and retired?
The equity expected return is much bigger than 1.92%.
It’s hard to gauge that without more info. How big is your retirement nest egg? If it’s $2m, why sweat $70k in the mortgage? You might as well keep the mortgage and invest the cash.
If you have $500k, and a major bear market would risk your retirement finances, why take the risk with the mortgage?
I have less than 500k. About 150k, including the 72.
When you say ‘why take the risk with the mortgage?’ do you mean why pay it off?
But between my pension, CPP and OAS all my monthly expenses are covered. I usually have about a couple hundred left at the end of the month. So not a huge buffer if any emergencies came up.
There you go. If you don’t face a cash flow constraint from your leveraged equity bet going against you, you might try keeping the mortgage and investing the money. 🙂
Thank you for your advice. After months of going back and forth I have finally decided to keep the $ and invest it. I am considering a Vanguard asset allocation ETF.
And I made the amortization period 30 years so it actually decreases my monthly payments at the same time.
Thanks again for your guidance!
Betty
Uhm, depends on the AA fund. If that has a lot of bonds you definitely DON’T want to hold bonds and a mortgage. I assumed you wanted to put that all in the stock market.
I was thinking 90% VGRO (80% equity and 20%bonds) and 10%VRE (REIT).
Total bond allocation would be 18%.
Too conservative?
If 18% are in bonds you’d be better off putting those 18% into the paying off the mortgage. Your bond yield is likely lower than the mortgage APR, especially after taxes.
VAB yeild is 2.53. My mortgage is 1.97. I don’t pay any taxes because I hold it in a TFSA.
Besides, it’s too late. My mortgage has already been renewed with no lump sum payment.
Well, then there is no choice anyway. But again, careful, don’t compare a mortgage interest (you MUST pay that) to a bond fund with a bonds fund that has corporate debt which can and has gone bust. 🙂
These are some excellent points and I am would have done things differently in hindsight. We had a 15 year mortgage at 3.375% interest and paid that sucker off in roughly 4 years. At the time, I thought the market was over inflated so we put extra money on the mortgage (while continuing to invest through our 401ks and IRAs but not extra). Fast forward to today, we would have more money.
I will say that I think it is a different discussion about being mortgage free pre-FI vs post-FI. The big advantage with no mortgage post FI is the cash flow requirement reduction. Our living expenses were cut by a substantial % with no mortgage which also reduces our tax bill (since we pay no tax on money we save with no mortgage). However, I would have done things differently and paid the mortgage at least until FI. This is a great analysis!
Very good point. There is a huge difference pre- vs. post-retirement. I always liked the leverage when I was younger, but now in FIRE it’s best to have low mandatory expenses! 🙂