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

Mortgage

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.

Student Loans

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.

Auto Loans

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.

Conclusion

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?

9 COMMENTS

  1. I always debate this. I hate debt and still have $170k of student loans at 3% and a home mortgage north of $900k at 2.8%. With the extra cash that comes in each month I debate paying off the loan vs the mortgage vs investing. The loan would disappear if I died and so in some ways I put that in the perspective of estate planning. Still I hate debt.

    For now I think I will go 1/3, 1/3, and 1/3 into each pile. That way they each grow (or diminish) equally and my net worth continues to climb.

    • DDD you say you hate debt. I find that hard to believe because you sure have a lot of it. Leverage is a useful tool is used properly. I am a commercial RI investor and use it. Never over 75%. Too much can go wrong and would never mortgage my house to invest in the market. The saying in Rei circles is leverage is awesome on the way up but a bitch on the way down

  2. This was a good post. I was a little unclear if the thesis of this post was to take on more or less leverage but to each their own. Personally, I got rid of all sources of debt within 6 years of finishing residency. I think keeping additional debt to use as leverage for additional sources of financial wealth is extremely risky if one looks at history prior to the last 30-50 years.

    One thing I do think that needs to be factored into this post on leverage is the effect of municipal/state/federal taxes which are/will begin to act more as a permanent non-principal bearing debt with variable (and likely increasing) interest payments. The next crisis will likely involve the muni/state/federal insolvencies and the first action will be to increase taxes (e.g. Illinois, Connecticut, etc). First these taxes may/will negatively affect the price of both financial and tangible assets. Second, if one is even slightly over levered, increasing taxes will make all these interest payments will become even more difficult to cover. Going forward, I would be very careful with debt. Even though being a doc provides at least some cash flow to offset these obligations, the biggest catastrophic assumption is that this source of cash flow will remain unchanged when everyone else is getting crushed. I am just waiting for people to begin arguing that health care costs and physician salaries have become a violation of the Hippocratic oath. (And yes, med school, residency, etc was somewhat painful for me as I am sure it was for all the others who are triggered by the previous sentence).

  3. Very interesting, I can see where someone with too much “good debt” can still be spread too thin in a downturn. Luckily, we fall into one category (mortgage) having paid off the auto and student loans prior to the mortgage. Thank you for sharing!

  4. Excellent article,

    I guess it shows that many people don’t really consider this when looking at their investment risk tolerance. If you want to be prepared for the worst possible scenarios, a few good reasons to pay off your student loans even at low rates are:

    1. Once you are an attending the interest is not tax-deductible. $3000 of interest per year is a nice vacation somewhere.

    2. If you get in financial trouble and hit the reset button with chapter 7 bankruptcy, you can eliminate mortgage debt, auto loans, and credit card debt but your student loan debt remains unless you can prove an undue hardship such as never being able to work again.

    3. Eliminates one more “fixed expense” from your budget if the hospital you work for goes bankrupt or similar events occur.

    We are in the slightly overextended boat but were investing the difference looking for higher returns in the long run. It’s a bit of gamble but I lean a bit to the optimistic side of things.

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