One of the most common questions in the personal finance community is whether to pay down low-interest debt or to invest the money in the stock market or other assets with high expected returns. You may have the cash to pay off your home or student loan debt and become debt-free, but feel that the money can be better invested in the stock market.
This reasoning makes financial sense, but it’s important to be careful before choosing to hold too much debt. By holding a lot of debt, even “good” debt like a mortgage or low-interest rate student loans, you are leveraging your portfolio and potentially taking more risk than you can handle.
Examples of Hidden Sources of Leverage
When you purchase a home that is financed using a mortgage, you are making a leveraged bet on your real estate investment. By putting 20% down (and many will put down even less), your returns (relative to your down payment) are amplified.
For example, if you put $20,000 down on a $100,000 home and finance the remaining $80,000 with a 4% 30-year mortgage, you are leveraging your real-estate investment by 5x.
If the home goes up by 3% ($3,000) in the first year, then you’ve made approximately 15% ($3,000/$20,000 down payment) on your investment.
If you had paid cash for your home, then you would have made the same $3,000, but this is only 3% of your $100,000 investment. Using a mortgage amplifies your real-estate returns.
However, if your home goes down in value by 3%, then you’ve lost 15% of your initial investment. If your home value goes down by 20% or more (as happened in many markets during the financial crisis), you’ve now lost more than your initial investment.
Most real estate investors utilize leverage in this fashion. They will often put as little money down as possible on a real estate purchase, because less money down means they can purchase more homes and amplify their returns (as well as their risk). In my opinion, real estate investors who pay cash for their homes are unlikely to achieve returns comparable to the stock market because they are not taking advantage of leverage.
Many physicians will not immediately pay off their student loans, especially if they are at a low interest rate. They may sit on a low-interest student loan for 20 years or longer, because they are borrowing money at such a low interest rate that it could be better invested in the stock market at a higher expected return.
I usually don’t recommend auto loans, but some people are able to get low-interest, or even zero-interest, loans for their car purchases. Again, the idea is that you are borrowing money at a very low interest rate, which can be invested in the stock market for a higher expected return.
Of course, as cars are a depreciating asset, you aren’t actually trying to make money off the car. But by paying off the car over several years, that money can be invested in the stock market and making money for a longer period of time.
What These Hidden Sources of Leverage Mean For Your Portfolio
By holding a mortgage, student loan, auto loan, or other low-interest loans, despite having the cash or investments to pay it off, you are leveraging your exposure to your investments. By holding the house, you will get all of the gains (or losses) on your house, no matter whether you have 5% equity, 50% equity, or 100% equity (i.e. paid cash) in the house. However, holding that mortgage allows you to have more money to invest in the stock market.
On average, it’s a winning strategy. But with leverage, you are now exposed to risk that you might not be able to handle.
Mortgage + Stock Investments + Housing Crisis = Potential Financial Disaster
What happened to the people who bought a house right before the mortgage crisis in 2007-2008? The stock market and real estate market, especially at extremes, can have very correlated returns, and this is exactly what happened during the financial crisis.
Many homeowners went underwater on their investments, and their stock investments fell by 50% or more as well. Someone who held both stock investments and a mortgage lost a lot of money, potentially even leading to a negative net worth during the financial crisis, depending on their individual circumstances.
While this in itself is not a big deal (so long as you can make the mortgage payments, it’s fine to continue making mortgage payments on the house and ride the housing crisis out). However, if for some reason, you could not make the payments, foreclosure or bankruptcy may be necessary to extricate yourself from your losses.
An Extreme Example
Let’s say you currently own a $500,000 home outright and have $500,000 in investments, all in the stock market. If someone offered you a low-interest rate mortgage with no money down, would you finance your home (take out a $500,000 mortgage) and put all of that money into the stock market? By doing so, you now have $1,000,000 in stock investments, but still own the house outright (with zero equity in your home). Your exposure to the fluctuations in the value of your home is the same, but you now have doubled the amount of money you have in the stock market.
The Example of Most Physicians
The natural course of most physicians’ finances is actually a slow de-leveraging of their portfolios over time. Medical students and residents take on massive amounts of student loans, and sometimes even a mortgage. Any stock investments they do have is heavily leveraged and financed by their student loans or mortgage debt. As they become attendings and start making good money, many will not immediately pay off their student loans and mortgage debt. Instead, they will pay if off slowly over years, accumulating a sizable stock portfolio in the process. As you get older and pay off your mortgage and student loans, physicians slowly de-leverage their portfolios, as more of their money moves away from the stock market and into home equity. At retirement, most physicians will have no debt at all.
The natural de-leveraging of your personal finances over time can be beneficial. Younger investors may choose to be more aggressive with their investments, while older investors often want to be more conservative. The typical behavior of the average physician towards debt ends up aligning with their risk tolerance over time.
The major takeaway from this article is to be cognizant of how much leverage and additional risk you are taking when you purchase your home and to consider paying off your mortgage more aggressively, or putting more money down when you buy your home. Or, you may be comfortable with the leverage a mortgage provides, and may choose to take a mortgage on a previously paid off house and pour that money into the stock market.
What do you think? What hidden sources of leverage do you have in your portfolio? How fast did you, or plan to, de-leverage your portfolio over time?