There is a common myth that debt ruins your chances at financial independence. Some kinds of debt can be a loathsome burden, and in that case it could be true. But, I believe that debt can actually help you achieve financial independence….but not for the reasons you might be thinking.
Reason 1: Lessons Learned the Hard Way
Everyone makes stupid financial decisions at some point in their life. From the $5 coffee to buying too much car. Those decisions can make us or break us. Paying off debt is nothing special, but using that debt to change who you are might have a bigger impact on your life.
In my life I’ve had more than my share of debt AND stupid decisions. The worst debt situation I’ve been in was soon after I graduated college. This was in 2001. I was in my early 20’s and living in Bend Oregon. It was a beautiful place, but Bend did not have a lot of high-tech employment (my profession of choice). My employer had recently filed for bankruptcy; leaving me with $50,000 in student loans at 5%, $8,000 in a car loan at 6%, no job, no family nearby, and no assets to speak of. Those were fun times.
But I dealt with it. I moved to a very crappy apartment to cut costs. The place was ancient, badly out of style, and I had to sign a bunch of “lead paint” disclosure forms to rent the place. The refrigerator in the apartment was probably from the 1950’s (must have been terribly inefficient). I had no cell phone, and I ended up riding my bicycle more than I drove my car. Spending was seriously minimized. I spent maybe $500/month, and only on rent and food. The rest went to paying on my loans. Entertainment was either non-existent or free. This was definitely a formative time in my life. Debt actually set me on the path to financial independence. I learned several very important lessons then, that have stuck with me up to today:
- Employer income cannot be counted on to pay the bills.
- Debt, without counter-balancing assets, sucks.
- Costs can be cut to almost nothing, and life can still be a lot of fun.
Once I found employment, I crushed that debt down to zero in just a few years and I put my foot on the savings pedal to the tune of about 50% (of after tax income) and never let off. All because of those lessons learned. Fast forward 15 years, and I could easily write a check for $300,000 to pay off my mortgage and still have over $1.5 million in assets. But, I won’t be doing that. Read on to find out why.
Reason 2: Higher Returns on Capital
I see this a lot in the Financial Independence community – people paying off their mortgage early. It’s great, paying down debt, especially consumer debt. But mortgage debt is a little different. The house itself, if maintained properly should maintain its value. Mortgage debt also has a very low interest rate, far below what might be paid on a car loan or credit cards. The most common argument for paying off a home loan is financial security: if something happens you will “still have a place to live”. Psychologically you feel safer, and not in hock to a lender.
Paying off a home loan actually isn’t actually financial security at all, only lower housing costs. Just because a mortgage is paid off doesn’t mean you won’t have any housing costs. Quite the contrary in fact – Besides a mortgage, there are significant and growing property taxes, home owners dues, and all the regular maintenance costs of a house. With most of these expenses you do not control the amount, or the timing when they hit. Housing expenses without a mortgage can easily break $1000 a month, and the longer you live in your house the more likely you are to need major maintenance, like roof replacement. That’s a cost that can easily exceed $15,000. Ouch!
There’s no getting away from it, housing is still going to be a cost for the rest of your life, even if you pay off your mortgage.
So what’s the alternative? There is really only one alternative: Choose the higher return on capital. Invest your money in productive assets. A house, by itself is not a productive asset. It does not generate cash flows, and you won’t wake up one day to find that another bedroom has appeared. Typically real estates prices grow only at a rate that matches inflation, but it can depend upon your local area. Your portfolio however, should be composed of productive assets that will grow over time exceeding inflation AND generate cash flows.
Let’s use my mortgage for example: I have a mortgage interest rate of 3.5%. With an interest rate of 3.5% you can easily find investments that will exceed that over time, including taxes. Why taxes? Most of this money will be coming from taxable accounts because you are already doing the smart things, like maxing out your 401k and other tax free accounts. If you haven’t done that, start there first.
In this same example, perhaps you are in a 30% tax bracket. You’ll need to make the 3.5% interest rate, plus 30%. That’s 4.55% This means you have a target rate of 4.55% to beat on your investments. If you can’t beat the target rate, you should be paying down your mortgage. With the long term returns of the S&P500 around 10%, I believe exceeding that target rate to be very achievable.
So, that’s the tradeoff: You can choose to have no mortgage, lower housing costs, and feel a false sense of ‘security’. Or, you can choose the higher return on capital, and have a larger portfolio. Over time it will generate growing cash flows to pay for housing expenses. It won’t be smooth, and it won’t happen all at once. There will be bad years, and there will be good years. The good thing is, your mortgage isn’t going to grow. Your portfolio will grow, and will generate productive cash flows.
You want financial security? How about being able to say “I could write a check to pay off my mortgage, but I won’t.”
It feels pretty good.