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)!