When is debt good?
There has always been an age-old feud in the money world that centers around one question:
Should we invest or pay off debt?
The “invest” camp claims they are smarter, more evolved, and that they understand money better.
The “pay off debt” camp claims being debt-free is safer, liberating, builds good money habits, and builds net worth.
So who’s right?
Is it really wrong to keep debt around and invest instead?
In my opinion, it depends on what kind of debt we are talking about.
I’m going to drop Robert Kiyosaki’s cash flow quadrant for reference here: We’re going to be talking assets versus liabilities.
Here is the gist of this graph:
Assets generate income. Liabilities make expenses and take your income. The middle class makes an income and then sends it out the door paying for liabilities and expenses. The wealthy make room between their income and expenses to invest in income generating assets.
When Debt is Good
Let’s take a mortgage on a rental property, for example. When we use a mortgage for real estate investing, we are using “leverage”– borrowing money to purchase an income-producing asset. An asset is something that has value and creates income. The mortgage is leveraged on the intrinsic value of the house and its ability to produce income as a rental (and backed by our good credit score and jobs, as a failsafe).
Let’s say we took out a $200,000 mortgage on a $285,714.00 property. We put down 30% or $85,714. Let’s assume we get a mortgage with an interest rate of 3.5%.
Our monthly mortgage and interest payments on a 30-year loan will be $898. Adding in insurance and property tax, our monthly payment will be $1,369.
Let’s assume this $285k property will bring in $2850/month in rent, satisfying the 1% rule. It will have expenses: maintenance ($2850/yr), vacancy (5%), management fee (10%), etc. Accounting for all of that, it will cash flow positive $813.49 net for us each month.
The property will appreciate in value over time, as well. AND we’ll get to write off the mortgage interest, maintenance, and the wear and tear each year (depreciation), from our taxes. Overall, we’ll have an internal rate of return of 17.34%, cash-on-cash return of 11%, cap rate of 7.19%, and total profit when sold after 20 years of $631,563.24.
Now that’s an asset!
What if we lost our jobs?
Well, if the property is rented, the renters will pay the mortgage and put money in our pockets to help pay our bills.
If it’s not occupied, we could sell it and maybe even get some equity in our pocket.
Rental property calculator from calculator.net
When Debt is Not Good
Now, let’s compare that to student loans. Say instead of a $200,000 rental property mortgage, we have $200,000 in student loans at 6.8% in standard repayment for 10 years. Each month, we would owe $2,301.60 toward these loans.
Would this loan make us money? Not the loan itself, no. The loan itself will cost us $76,192.79 over the life of the loan. The loan will provide us with a way to get a well-paying job to help afford these payments. How much will we need to make to afford these payments? $345,240 a year to be exact.
But what if we wanted to take a break or cut down hours? We’d have to figure out how to pay the expense of our $2,301.60 student loan payment, plus our mortgage and other living expenses, on the decreased pay.
The point is, this borrowed money will need to be paid back with our labor, our time, and our life energy, at some point. We have no renters to pay it for us. We cannot get rid of it by declaring bankruptcy. Sure, we can hope the government will forgive some of it, and the payment pause for COVID relief has been nice. But, at some point, the payments will restart. No one is talking about wiping out the debt of high earning professionals, so I wouldn’t count on anyone wiping away $200,000 of student loans by legislative action. The bottom line is, student loans are leveraged on our life energy and our working ability. In this case, we are the income-generating asset… for someone else (Uncle Sam to be specific).
Student Loan Payment Simulator from Mappinyourfuture.org
The difference between student loans and real assets
Real assets are not leveraged on our life energy. Real assets bring in money while we sleep. Student loans require us to work at a certain level until they are paid off. The money that goes to them every month builds wealth for those who own the loans, not us. Student loans are a liability.
Sure, we can pursue public service loan forgiveness or participate in an income-based plan to get governmental help to pay off our loans. That would decrease their overall interest rate and make the student loans less of a burden to carry. But, these methods still don’t make student loans an asset. They are still a liability. If someone was wanting to work full time for 10 years or however long it takes to get the loans paid off, then investing instead of paying off debt would make sense. But, if someone wanted to cut back hours or modify their work schedule to bring more balance, they may not be free to do so as long as they carry this debt.
Usually, the people that don’t get why medical student loans are such a big deal have never worked in medicine, or have never had this much student debt or if they did, they never had to pay the loans off themselves.
What paying off student loans did for me
I can tell you this: My husband and I paid off $208,000 of student loans in 17 months. That’s an average of $12,235 a month. We did this while holding on to an asset (cash flowing rental property), increasing our income by Josh going back to work, investing some in retirement accounts, cutting back our expenses, and negotiating loan payback into my contract.
And in 3.5 years (including that 17 months mentioned above), our net worth has risen by a million dollars, even while I cut back my clinical hours. How?
Because we ditched a liability (my student loans), maintained assets, and once my loans were paid off, we had even more money to put towards investing and building more assets. Paying off my loans built our net worth, too. And, it gave me back my time and my freedom.
So, when the investing crowd says investing is the only way to build wealth, I call BS. That’s just not mathematically sound.
Investing in assets, whether in real estate or in the stock market, is an important part of building wealth. However, minimizing liabilities is the other important part of building wealth.
Cash flow = income – expenses.
We ignore liabilities and the expenses they create at our own peril.
Focusing on income alone is a mindset block, a limiting belief.
If you’re a high-income professional and you have to ask, “Should I invest or pay off debt?” you’re doing it wrong.
As a doctor, you shouldn’t have to choose one at the exclusion of the other. You make enough money to do both at a relatively rapid pace, as long as you’re… well, you know… frugal.
When it comes to paying off student debt or investing, the question really is- how fast do you want to pay off your debt and how fast do you want to grow your investments? Which debt do you want to pay off fast and which ones do you choose to keep around?
The answer, my friends, is in your heart, your mind… and in the numbers.
And stay frugal, y’all!
Standard Disclaimer: Not meant as individualized financial or medical advice. If you need help, please consult a financial professional to go over your unique situation.
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