(This is a post series on a complicated topic. It will focus on traditional “good debt” forms such as student and mortgage debt. I will be the first to say debt is an incredibly emotional concept and there is no “right answer” for anyone. Similar to my discussions around asset allocation to bonds/equities, each individual has to reflect on their own behavior when it comes to both debt and stock market volatility.
Despite the above, I believe there is typically a theoretical optimal approach if an unemotional robot were to apply financial models to an analysis for any given set of variables. My goal here is to help readers understand each variable and their individual importance weighting on a multivariate problem. Once you understand the practical data, you can meld it with your emotional behavior to optimize your individual situation. As always, I will start slow and work my way through.
Hope you enjoy – this will be a long one over several posts so bear with me!)
Since starting this blog, I have greater appreciation for the nuances of financial planning than in the beginning of my financial journey. I analyzed my personal situation to death in my mid 20’s to the point where I felt a high degree of confidence in the general asset allocation and investment strategies I would pursue. I now have more professionals and new grads asking me what I would do given their specifics on age, gross income, diversity of income sources, financial goals, debt levels and current assets.
The #1 question I get asked: Invest now or pay off the big student and mortgage debt? It seems especially common given the rising interest rate environment that has occurred and is expected to continue in Canada.
The more situations I see, the more I realize that blanket advice on the correct approach will lead to sub optimal outcomes. Given that I am not a financial planner, I am left explaining why I chose my specific direction in order to allow the individual to apply the principles to their nuanced situation. I do think conventional financial planning wisdom and blogs ignore some unique variables that apply to most medical professionals.
My hope here is to dig deeper into the roots of the question over the course of several posts rather than writing a quick synopsis that leaves no one further ahead. This will draw out the main factors involved in a complex, emotional decision.
Why Did You Take on Student Debt?
This seems like such a stupid question to ask, but it will drive down into a key part of the analysis.
As an undergraduate, the debt was taken due to a belief that a university degree will increase the chances of future earning potential. Of course there are maturing life skills that are also obtained by post secondary education, but I am focusing on the financial perspective. The expected risk of student debt is not insignificant:
- there is no guarantee of graduation
- there is no guarantee of a job in your field of study
- there is no guarantee of increased earning potential compared to jobs straight out of high school (think liberal arts degree vs trades skills employment)
- there is no guarantee you have many years to enjoy your increased earning potential ( think disability, job replacement and disruption, alternate life planning)
As an ambitious, intelligent individual, you may have felt these risks were minimal and worthwhile to take on. This view may have been very reasonable, but the bank will very rarely take on the student debt risk of an undergraduate. That is why this is typically left to federal/provincial programs as the private markets deem the lending risk too high.
The absolute risk of student debt is declaring financial bankruptcy from inability to pay. How often does this actually occur though? Default rates are quoted in the 10-11% range by Canadian statistics on federal/provincial loans. This is with the government being a kind lender with numerous adjustments to debt repayment plans being possible.
If the risk is not minimal, is it essential to borrow for education? All borrowers would have an option to work an alternate job to SAVE the cost of a degree. This would mitigate the risks noted above, but may be a sub-optimal choice because of one primary factor.
The above concerns don’t change the fact that student debt is often a form of good debt that enhances most students’ financial future. Good debt increases your financial assets, while bad debt typically comes in the form of personal consumption.
A key component of the debt analysis is the time horizon attached to the improved earnings potential. This example shows it well.
Example #1: The Late Start GP
I have a friend in her mid 30’s who was unsatisfied in her career and was interested in becoming a family doctor. She would have to do 1-2 years of undergraduate classes and would need to take on debt to achieve the desired outcome.
We reviewed the anticipated costs which came to $175K of debt by the end of medical school residency. We anticipated an earliest completion of schooling after 8 years, assuming she got in on her first try. When contemplating starting a new career by 43 years old with $175K in debt, she was unperturbed – “Look at that Earning Potential Though!” she exclaimed.
After I walked her through office expenses, personal tax rates and interest costs, she saw that it would take 7 years to be debt free and 10-11 years to be at break-even compared to continuing her current career path’s earning potential. She would be 53 years old at break even!
Her option for debt was too high risk/reward given the reduced time horizon of hypothetical future increased earning potential. The same analysis if she was in her mid-20’s would have a very favorable risk/reward, especially if she had no other skill set to enhance her current earning potential.
My point of this section is to strengthen the belief that although debt is almost never essential, it is often OPTIMAL in certain scenarios where a long time horizon is present.
Why Did You Take On Housing Debt?
It was a somewhat facetious post, since I don’t actually believe your primary residence should be considered an investment at all and I also think most professionals buy way too much house and thereby slow their financial progress.
The primary purpose of the post was to introduce the concept of leverage in a form that most readers would understand. It attempts to show that the borrowing effect is the primary feature that leads to out sized levered nominal returns over a long time horizon.
Most Canadians do not think of their primary residence purchase as borrowing to invest. Similar to the student debt situation, they believe the debt was ESSENTIAL to facilitating a home purchase. Yet the same feature noted above makes this factually incorrect.
The lowest risk way to purchase a home is to save the entire purchase price and own the home outright upon purchase. If given no option to finance via debt, many people would choose to rent vs own given the huge endeavour to save such a large lump sum.
There are a few large dilemmas that arise from the “no debt” home purchase approach:
- You spend away a decent chunk of your housing budget on rent while you build up all the equity to purchase an asset you planned to get anyway.
- You reduce the time horizon for the expected increased compounding value of the housing asset in the future
- You can’t use the house down payment savings for any meaningful investment while accumulating the cash. Funds being held would need to be held in GIC’s or money market funds which produce very low investment yields. This is because higher return assets like stocks have higher volatility in short time frames and as a result you could end up in a temporary situation where stocks have declined in value, and as you need to save even more for that down payment. Investments need to always be linked to the time frame that the money is needed in the future.
Currently mortgages in arrears are quite low in Canada at a national average of 0.24% of outstanding mortgages. Real estate crashes have happened in Canada before and most recently in the United States when peak State default rates were 10-12% with a national average of 4%. I think it is fair to say banks are much happier to lend large sums for mortgages, because the default rates are low and they have collateral (something pledged as security against the loan) in the form of owning your house until you pay it off.
Most Canadians choose the logical approach – they RENT to OWN the housing ASSET from the bank via debt and accept the market volatility risk for the housing asset in the short term, with hopes for price appreciation over the long haul. This is not truly essential or the lowest risk approach, but debt is the OPTIMAL choice given the long time horizon for the financial asset.
A Variant Viewpoint on Your Student LOC
Did anyone else find it incredible that after being accepted to medical school a bank threw $150-$250K at the cheapest borrowing rates possible (prime) to everyone in the class like it was nothing? There are around 2500 Canadian students entering into medicine every year which means banks are lending $375-625 million every year to new students that essentially have zero net worth and a minimum of 6-10 years before any chance of receiving some form of payback! This sum ignores dental and other professional students that get similar LOC’s. Why are the banks so discerning for standard loans but not to irresponsible 20 something year olds with no net worth, no income and NO COLLATERAL?
This lack of lending standards from the banks compares to:
- Avoiding undergraduate debt altogether
- the average working individual getting an LOC at prime + 1-3% on a fixed short term basis for very small sums of money after an intense adjudication by a lending underwriter.
- Requiring a fixed payment schedule and collateral for a mortgage with strict lending requirements
There are likely many reasons for the bank’s lower lending standards such as:
- Establishing a relationship for all your future professional business
- Earning interest for a long stretch of time on a captive borrower
- Getting a professional into the heavy spending debt trap early
- Regardless of the motivations, one reason is quite important to comprehend:
Banks would not lend these large sums of money indiscriminately if the outcomes did not show incredibly consistent rates of successful lending with minimal defaults.
Why is this fact important?
The banks immediately shifted their perception of your debt risk profile as a borrower when you went from an undergraduate to a professional student based on their own objective historical repayment data. The “Collateral” they are accepting is your very high likelihood of job stability and consistent high income earning potential.
If the banks feel so strongly about your excellent debt risk profile to lower their lending standards, should you adjust your personal risk profile to take on good debt too? Are you different than the average Canadian when it comes to debt risk? To analyse this complex question, we need to consider all the variables involved in debt.
The main points I am trying to drill home in this post are:
- Debt is never absolutely necessary, but is often the optimal choice to benefit from time horizon.
- Banks are in the business of evaluating risk. You are a bad bet in undergraduate (11-13% default risk) and a good bet for home mortgages given the collateral and low default rate.
- A student professional is given a huge optional loan, often with no assets/collateral and a very long road till future repayment. This does not exist for 99% of borrowers out there. I think it is reasonable to assume the default rates on these loans are very low and doctors are in a better position to take on debt compared to the average Canadian.
- Time horizon has a big factor when considering if debt makes sense to take on or continue with. More proof on this to come.
- “Good Debt” can often be the optimal solution to a problem, but it needs to be appropriately weighed with its risks.
Common wisdom suggests that taking on good debt for education and housing is the appropriate decision for most people and I would agree. Both are felt to be positive predictors for financial success despite being higher potential risk then incurring no debt at all.
What would common wisdom say about retirement planning? Does it not feel like debt repayment is limiting your early start at wealth building? Is there a good debt version of the story here? The Rent to Own concept for houses makes a nice segue into a thought experiment I found helpful when analysing the debt vs invest conundrum. I will explore this in the next post.