Debt Is Evil?
Many people have an irrational fear of or hate for debt. Debt like any tool can be used for your benefit or harm. I think the issue stems from so many stories of people misusing debt and getting themselves in trouble, that there is a natural pushback to avoid and eliminate all debt. I believe that we are capable of a much more nuanced approach that will be more optimized for your finances. Debt provides leverage so that your investments will have increased returns.
How to Misuse Debt
The most common debt for individual investors is a mortgage on a house. You gain control of the entire house and all the benefits it gives for a fraction of the price of the house. You can consume the benefits by living in the house or you can sell those benefits to someone else in exchange for rent money. The reason that mortgages are looked down upon is that many people misuse this debt to increase their housing consumption. Housing is already most people’s biggest expense so increasing this expense by buying the biggest house you can get using leverage has dramatically negative effects on a person’s finances.
For example, Cody currently pays $1,000 a month in rent for his family to live in an apartment or small house. He also has $100,000 in his saving account. A misuse of debt would be to put $100,000 down on a house worth $500,000 to live in. This would increase his housing consumption to closer to $5,000 per month (a reasonable amount to rent it for). This is what opponents of debt think of when they think of debt. Most thoughtful people would recommend that Cody spend $100,000 to buy a small house of equivalent size to his current house that keeps his housing expense at $1,000 per month. I agree that this is a far superior option than buying the $500,000 house because his housing expenses are the same.
To compare the options let’s assume that Cody will put 20% down for either house and have a 15 year fixed mortgage with a 3.3% APR (Current 12/24/17). He can also expect to get 6% annual returns in the stock market (2% current yield + 4% growth) averaged over 15 years. I know that actual results will be more volatile, but I think 6% returns with a 15-year timeline is reasonable. We will also assume 4% annual growth of house prices. Many would say this is optimistic after the large run-up in prices while the housing market crash still in recent memory for most investors, but a higher number favors the larger house and I don’t think 4% growth is unreasonable. Either way, I made the spreadsheet so that you can easily adjust the numbers I used for my assumptions.
In both cases, the house is paid off in 15 years. The big house is worth $900,472 which is a nice gain of $400,472! This is easy for people to see and talk about so these gains get noticed more. The small house is only worth $180,094 for a gain of $80,472 which doesn’t seem as impressive, but what is often left out is that the stock investments grew to $829,261 for a total net worth of $1,009,355. This is almost $100,000 more than Cody would have buying the big house and doesn’t even factor in all of the increased maintenance costs the bigger house would require—HVAC, repairs, cleaning, etc…
Never Use Debt?
Debt opponents would alter this strategy to say that Cody should buy the house without a mortgage if he has the money or pay off the mortgage as quickly as possible. Rarely are either one of these strategies the optimal way to handle the situation. The optimal way to handle this situation will need to take into account the interest rate that Cody can borrow money for and the expected investment returns Cody can make. Right now at the end of 2017, with a good credit score, Cody could get a 15 year fixed loan with 3.3% APR. Cody could also expect to get about 6% returns being 100% invested in the stock market according to Jack Bogle based on a 2% dividend yield and 4% earnings growth (requires long-term time horizon due to volatility)
Let’s compare two options the first buying the house free-and-clear and investing the avoided mortgage payments into stocks and the second option of getting a mortgage and investing the excess money into stocks. In both scenarios, Cody will own the house and have it paid off in 15 years. In both scenarios, Cody will be paying $6847.58 per year either toward stock investments in the first option or the mortgage in the second option. By taking on debt Cody will have an extra $32,000 in 15 years when his house is paid off with no adjustments in lifestyle.
I know this is a highly contested topic, so please let me know what I’m missing that makes paying off the mortgage early ideal. One additional consideration is that a mortgage payment or any other leverage can increase sequence of return risks when you stop working. ERN makes an excellent case for this here. Will you keep a mortgage or pay off your house early? Why?
You may also be interested in my article on shopping for mortgages here.