(This is a post series on a complicated topic. 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. These posts are not blanket advice on debt management to everyone.
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 own situation.
Hope you enjoy – this will be a long one over several posts so bear with me!)
This is part 2 of the series. Catch part 1 here if you haven’t read it already.
Why Do Savings Always Come Too Late?
I preached in the beginning of the blog that it should be easy to save high percentages of your income since professionals often have high earning potential. The problem is that it never seems like an opportune time to save in the beginning of a career.
The last post established why both student debt and housing debt can make sense to take on despite having some risk. Conventional societal wisdom would say:
- Pay off student debt, find a partner and get married
- Buy a house and have some kids. Pay that housing debt down aggressively
- Now get serious about retirement saving
The issue with this conventional wisdom is all about timing. Building a family with children brings an incredible amount of joy to life. When it comes to money however, they are nothing but financial leeches – I should know, I have 3 bloodsuckers at home that I will happily remain host to for years to come! This creates a new 20 year stream of spending where money flies away in every direction.
By the time kids are out of the house that is finally paid off, you are finally in a place to sock away a decent chunk of cash for retirement. The only problem is you are in your late 40’s or 50’s and you need your retirement money in 10-15 years!
Many retirement asset accumulation studies have shown that the bulk of the final retirement portfolio is built up in the last quartile of working years based on both the life variables noted above and earning power often being higher in latter working years.
This is from a previous post that showed the difference between starting early with compound interest in the example of Average Joe vs Rich Mitch.
“A) Joe learned the value of saving early from his parents. He had read some finance blogs like Mr Money Moustache that gave a blueprint for frugal living. He decided to quit school early at age 18 to work in the trades. He made about $17/hr or $35,000/ year. His early life had little costs with no dependants so he could save $1500/month or $18,000/year. As life went on, Joe increased his training with an improved hourly rate, but now had a family with more expenses. He could have tried to save more, but he let lifestyle catch up a bit like most people do. He decided to just keep investing the same $1500/month amount forever and felt secure his retirement would be safe. 50 years later, Joe has saved $900,000 total and earned a CAGR of 7% over 50 years after fees.
- B) Mitch is a successful medical specialist that has studied hard and been in school a very long time, including some fellowship training. He finally began to work at the age of 35 with about $250,000 in debt. He earns a huge gross annual income of $440,000 and is left with about $330,000 after overhead expenses of 25%. Mitch thought about incorporating, but he has a young family with a new house and a large mortgage. He feels uncomfortable with so much debt and wants to prioritize paying it down. He needs to receive all his income personally to make the house and student debt payments along with his living expenses.
Mitch pays about 40% tax on the $330K personal income, which leaves him with around $200K after tax. He has a mortgage and housing costs around $5000/mth or $60K per year, and his family enjoys a nice doctor lifestyle spending $100K/year. He has around $40K/ year to pay off the $250K student loan/credit line off each year. After factoring in the extra $30-40K in interest over the life of the student credit line payment, he was able to be debt free in about 7 years.
Now that his big debt is done, Mitch is ready to invest by the age of 43. Let’s imagine he can now incorporate and defer some taxes by retaining income in his corporation. He now can save $100K/year on a tax deferred basis inside the corp and does so for 25 years to invest a total of $2.5 million by age 68 when he retires. He was pretty financially savvy and invested in indexes to enjoy an 8% CAGR over the life of his investments (1% more than Joe)
To summarize, Joe has invested $900K and Mitch has invested $2.5 million or 2.77x as much as Joe. Mitch also achieved 1% better overall on his investments than Joe. Joe’s only advantage is starting his compounding 25 years earlier. At age 68:
- A) Joe has $7.32 million
- B) Mitch has $7.31 million
If Joe had the same investment 8% returns as Mitch, his amount would be $10.33 million or 1.41x greater the amount of Mitch. “
The primary point of this example is to demonstrate that a significant amount of money is lost because our lifestyle spending cycle doesn’t fit with your retirement saving lifecycle. What could have happened if Mitch directed more of his cash flow to retirement early and either bought less house or paid down his debt slower? What options do you have to beat the lifestyle trap?
The Rent To Own Retirement Plan
I used the rent to own analogy for buying your house since I feel it is the most accurate representation of who owns the house primarily – the bank. The primary benefit the borrower receives is the ability to direct the required cost for housing towards building home equity over a long time horizon.
Most will agree that retirement savings are a REQUIRED cost to make it through the years we no longer can viably work. Pension plans for employees create a forced savings structure right from the beginning of employment. Professionals have no structure for forced savings and need to rely on financial education to see the benefit to early saving and long term compounding. Unfortunately, this rarely happens.
I have always wondered what would happen if banks made a “rent to own retirement plan” similar to the “rent a primary residence” mortgage loan that leads to forced retirement savings similar to building home equity through paying down a mortgage.
The following is a somewhat crude example to illustrate what this might look like, along with more standard saving circumstances. This is not a perfect example and I will mention many possible critiques after. All the calculations can be verified through simple compound growth calculators and mortgage type amoritization calculators.
These examples will assume no student debt for simplicity purposes. This concept isn’t meant as an endorsement to immediately go re-create such a scenario, but will be a thought experiment to understand variables in debt decisions.
Example A: Rent to Own Retirement Plan (30 yr growth)
Imagine Jane, a 30 year old new grad, was able to approach a bank to create a rent to own retirement portfolio. What would it look like? Let’s imagine $100K in savings, a 30 year amortization loan structure and a 5% interest rate. If this was a home purchase, the $100K in savings would act like a down payment and allow the borrower to have a $400K mortgage based on the typical 20% down requirement.
I will assume that Jane doesn’t contribute a single dollar to extra savings – she solely makes her “rent to own retirement payments”. The bank holds the whole retirement account as collateral similar to a house until the loan is paid. This would mean Jane could never remove any investments from the retirement portfolio unless the loan balance was paid out.
To make the calculation easy, I will assume interest rates could stay static over the 30 yr term:
Monthly payments at 5% interest would be ~$2130/mth
Total Interest Payments over 30 years = $368,500
Growth of $500K ($100K principal and $400K loan amount) over 30 years at 7-8% annual return =
$3.8 million on 7% return
$5.0 million at 8% return
Remember that there is no further debt at the end of the 30 year period as the loan has now been paid in full. These final figures are factoring in all the interest payments to the bank over the life of the retirement loan.
Example B: Early Savings Jane and Regular Investment Plan (30 yr growth)
What if Jane took the standard approach and placed her $100K in a retirement account, then placed the equivalent rent to own monthly payments of $2130/mth into regular monthly investments. This Jane is getting the benefit of early forced savings like a pension, but does not have the leverage effect that Rent to Own Jane has.
After 30 years; she would have:
$3.25 million at 7% compound return
$4.0 million at 8% compound return
Example C: Slightly Delayed Savings Jane and Regular Investment Plan (20 yr growth)
The difference in Example A and B is significant, but not really something to write home about. Yet I am making the BIG assumption that Jane actually does start early savings at age 30 to allow compounding to happen. Most studies show she would not start investing diligently until her last quartile of working years.
If I give ”average” Jane the benefit of the doubt and have her doing the required saving by age 40 (1/3rd of her way through an average career) and giving only 20 years of compounding effect, her final portfolio amount after $100K start with $2130/mth regular investments would be:
$1.47 million at 7% compounded return
$1.68 million at 8% return
This scenario is more realistic to the lifestyle trap factors that will delay investment even for the most diligent professionals. This is very similar to the examples given in my prior compound interest post that compares Janet and Jill. It shows why time frame of investment is the biggest asset.
Example D: Slightly Delayed Savings Jane at Double the Amount Regular Investment Plan (20 yr growth)
Some people might assume that clearing debt early allows for larger cash flow and savings later on. This example had no debt for simplicity, but let’s see if Jane can catch up by investing double the amount after the 10 year delay. If I increase her savings to $4260/month with the same $100K down at age 40 she has these amounts after 20 years:
$2.55 million at 7% return
$2.89 million at 8% return
The table below summarizes the difference between the different Jane scenarios:
|Rent to Own
Jane 30 yr
Jane 30 yr
|Delayed but Double Savings
Jane 20 yr
|Delayed Savings Jane 20 yr|
|7% compound return||$3.8 million||$3.25 million||$2.55 million||$1.47 million|
|8% compound return||$5 million||$4 million||$2.89 million||$1.68 million|
We can see that despite losing $370K in interest to the bank, Rent To Own Jane does quite well given the early start and larger amount of upfront invested capital ($500K vs $100K). There is a stark contrast for the 10 year head start more than any other variable change.
An astute reader might make several significant objections to why the Rent to Own Jane scenario does better than the other Jane’s.
- I cherry picked the historical 7-8% returns of an only stock portfolio – what happens if you have lower returns from a more balanced portfolio?
- I cherry picked a 5% interest rate – what if rates went higher?
- What about tax implications?
- A fixed interest rate for 30 years doesn’t exist even on a mortgage. How does the unpredictable nature of interest rates factor in?
- Stocks have far greater volatility then housing and therefore are riskier. Isn’t it unrealistic to think Jane can borrow $400K against $100K asset? (4:1 borrow ratio or 20% down)
- In a realistic world after graduation, the rent to own example has Jane taking a huge amount of debt at age 30 when combined with her student +/-mortgage debt. Isn’t this excessively risky?
- What about Jane’s emotional behaviour with so much borrowed capital?
All of these questions/observations are perfectly valid and are the key concerns for anyone evaluating the debt vs invest conundrum. The next series of posts will “stress-test” Rent to Own Jane with different bad scenarios to figure out which variables seem to have the most impact on the downside.
Final Thoughts – Capital Allocation and Debt
I can appreciate that this post appears like I am advocating for stock market leveraging but I am not. I can also appreciate that this Rent to Own Scenario doesn’t seem to have anything to do with choosing to pay down student or housing debt. Yet the concept of Capital Allocation does make the Rent to Own Scenario applicable to this discussion.
When an amount of capital becomes available in excess of what is needed to live, the decision of where that money is directed to is Capital Allocation. Optimal allocation would mean that money has been directed to the best use of that capital given all the variables in your financial status (age, net worth, income stability, asset and debt profile, risk tolerance etc) at that given moment in time.
A key insight I made just as I graduated residency was that if I chose to allocate any excess capital to an investment INSTEAD of paying down debt, I WAS LEVERAGING TO INVEST.
This seems non-intuitive, so I will use a hypothetical example:
I have just graduated medical school and have $100K LOC balance outstanding at 4% interest cost. I then have $10K in excess capital and I need to decide how to allocate it.
Option A: Pay down debt and not invest
Loan balance becomes $90K and I have $0 investment portfolio (asset)
Option B: Invest $10K directly and Pay Down No Debt
$100 K debt balance and $10K asset (investment)
Option C: Pay Down Debt, then 1 week later decide to Borrow $10K To Invest (Leverage)
$90K student debt + $10K investment debt = $100K debt balance
$10K asset (investment)
When you compare the asset/debt mix between Option B and C, you can tell that both have identical asset/debt mix on a practical level and would have the same interest cost on the debt. This means that any time you invested when there was still debt outstanding, you have created a “mini” leverage or Rent to Own scenario regardless of if it was for $100, $1000, or $100K.
Given how capital allocation works, whatever is optimal for the next $10 to use will likely be the same answer for the next $10K, ASSUMING you have downside protection on your debt profile. Obviously there is much more to unpack here in this complex topic so the next posts will be all about evaluating the downsides of choosing to invest instead of pay down debt.
The key take aways from this post:
- Life-cycle spending works in the complete opposite of optimal life-cycle investing.
- Rent to Own Jane may be onto something with a larger amount of early invested capital despite having debt, but the downside still needs to be investigated.
- Choosing to not pay your debt and allocating to investing instead is actually a form of borrowing to invest or leveraging.