Level 1 – The Basics – Debt

You are on part 6/9 in the Level 1 – The Basics series. Next up: Investing

1. Why Retire Early? 
2. The Basics – Overview
3. Income
4. Savings
5. Spending
6. Debt
7. Investing
8. Withdrawal Stage
9. Your Life In Retirement

Income, savings, and spending, drive success towards financial independence and achieving early retirement.

Debt, on the other hand, is the wildcard. It can completely cripple any chance of reaching financial independence or, it can be an accelerant and turbo charge the dollars coming in the door.

I view debt in five separate buckets:

Mortgage. Mortgage is a term that describes a loan for a piece of real estate. Most folks know a mortgage as the bill they pay each month to keep their house. There are various types of mortgages available, and each have their benefits and drawbacks. We will go into home loan options more in Level 2.

The average American has a mortgage loan that totals $173,995 (Data).

Or in other words, their name is on a sheet of paper, but the bank owns $173,995 worth of the house they live in. When I talk to people, most say they “own” their home, or that they are a “home owner”. In reality, they only own a fraction of the home they reside in. For most folks, the bank owns the majority of their home. Over time, if they continue to make mortgage payments, they will eventually “own” their home once the debt is fully paid off. Total mortgage debt in the US sits at a staggering $8.74 trillion (Data)!

Now, when most people think of personal finance and debt, red flags start running through their mind. Most of the time, this is true, but not when it comes to mortgages…it’s complicated. Let’s explore.

First assumption we need to make is that shelter is a critical need for life, and everyone must attain it by some means. Assuming we are all on the same page, let’s try a Bob example with some numbers.

Example:
Bob buys a house worth $200,000 and puts 20% down, or $40,000 in cash. Therefore, he owes $160,000 at, let’s say, 4% interest. His monthly payments will be based on what is called an amortization schedule, which is simply a schedule showing how much of your monthly payments go towards the loan principal, how much you owe, vs. how much of the monthly payments go towards interest. Using a simple amortization calculator (Helpful Tool), we see that Bob has a $764/month payment over the next 30 years to pay off his home, and actually gain home ownership at that time.

Some other key assumptions for this example:
Age: 25
Current Savings: $100,000
Salary: $100,000
Take Home Pay: $80,000
Spending: $50,000
Yearly Savings: $30,000
Spending/ THP Ratio: 38%
Market Gains: 9%

Assuming Bob sticks to his amortization schedule and makes his $764 payment and nothing more, when can he retire? He can pull the plug after 14.5 more years of work. At that time, he will have accumulated nearly $1.25mm in assets, or 25x his annual spend of $50,000. Bob would be 39 years old. Awesome!


Ok let’s take the same stats as above, but assume he takes his $30,000 a year in savings and applies it to his home loan. After 5.33 years, and $160,000, he has paid off his mortgage and is officially a home owner. Going forward, he no longer has mortgage payments to worry about, and has an additional $9,168 a year to invest ($764/month mortgage payment X 12 months). This gives him $39,168 a year to invest towards financial independence, or 27% more than the $30,000 in the first scenario. The other neat thing, now that he no longer has mortgage payments to worry about, his annual go-forward spend drops to $40,832, a 20% reduction.

In the first scenario, where Bob pays off the mortgage over 30 years, his spend remains at $50,000/yr due to mortgage payments continuing well into the future. In that scenario, Bob had to accumulate $1.25mm, 25X his spend of $50k/yr. In the accelerated payment case, Bob only has to accumulate $1.02mm to become financial independent, 25X his spend of $40,832. In the accelerated payment case, how soon does Bob reach financial independence? 41 years old, after 16.5 years of work.

Still awesome, but Bob worked an extra 1.5 – 2 years because he paid off the mortgage early! What?!?!


Yeah, did I mention that mortgage and home loans can get complicated? Despite having a lower annual spend going forward and being able to invest 27% more each year, in the accelerated payment case, Bob missed out on critical early years of investing and compounding. Investing early and often is crucial to help you achieve financial independence as early as possible. Even though Bob has a higher spend in the 30 yr. payment scenario, he is able to amass wealth at a more rapid rate, and is able to cover those higher expenses with his savings earlier in life. This is a great example of how debt can help accelerate your path to financial independence.

However, there are a few caveats to mortgages.

1) If you buy a house that is too big and costs too much, your monthly payments will be so large that your savings rate suffers. This won’t work. Make sure you buy a reasonable house, well below your means, and save as much as possible.

2) If you know yourself and must have expenses as low as possible before you jump into early retirement, go ahead and pay off your home ASAP. If you understand paying off the mortgage now will make you work longer, but you’ll sleep better at night with less debt, then go for it. Most people fall in this bucket, it is just human nature, and nothing wrong with it.

If you enter early retirement with the stress of a mortgage hanging over your shoulder, you likely won’t enjoy it one bit. Instead, you’ll be petrified to spend a dime. The whole point of early retirement is find more joy in life, and for some folks, the stress of lingering debt removes all potential joy. A key to early retirement is to know yourself and stay true to the approach that brings you the most happiness, whether or not you have to work an extra year or two.

3) At time of writing, March 2018, interest rates for a 30 yr. mortgage with 20% down payment fall in the low 4% range. If by chance the market changes and rates creep up to 7% and above, the logic may change. This would be the time to reevaluate the need to pay down the mortgage early or invest in the market. Historically, mortgage rates have been as low 3.4% in 2013 and as high as 17.6% in 1982 (Data)! Things can and will change, so make sure to stay tuned.

4) Lastly, you can always rent. This payment will be recurring for the rest of your life, but if you invest early and often, you’ll amass enough wealth to take care of the monthly payments.

Now on to the other debt buckets.

The rest of the debt buckets are much simpler than mortgages.

Credit Card Debt. This one is a no brainer, get rid of credit card debt asap. Make it the very first thing you pay off. Credit cards frequently have interest rates of 10% – 15%, or higher! Do keep multiple credit cards around and use them for every purchase. It is a great way to track your spending, and you get cash, travel points, or gifts back in return for your spend. Just make sure to pay off the balance immediately, and never send an interest payment their way. This would be money flushed down the toilet.

Student Loans. Similar to credit cards, pay it off. Make it second on your list of things to pay off. Typical student loan interest rates range from 3% – 7%, but can sometimes fall outside this range. You could apply the same logic I used in the mortgage example, hang on to the student debt, and instead invest any discretionary dollars in the market.

However, I am a big fan of simplifying your finances, more than one form of long term debt lingering over your shoulder just doesn’t feel right.

Also, most of this debt is picked up when you were 18 and just starting college. If you are in your late 20’s or early 30’s, or older, and still have this ball and chain following you around, the psychological impact can be crippling. How easy is it for someone to say “I’ll start really worrying about my future, saving money, and planning my retirement as soon my student loans are paid off.” So many folks use student loans as an excuse for not saving more. Same thing as starting a diet next month.

If you really wanted to start a diet, you would start today, not next month. The person that says they will start next month is the person who is not committed to actually making a change in their life.

Do it now, commit yourself to getting rid of those student loans.

Auto Loans. Same as above, pay it off. Simplify your finances, pay this debt off, and move on down the road.

If by chance you have more than $10,000 in auto debt, trade in the car, and get a more affordable car. Unless cars are your only hobby, no one needs an extravagant car. I know I have said it multiples times, but the more you can simplify your finances, the more likely you are to be successful and meet your goals.

The only caveat to auto loans is if you have a 0% loan. These are offered from time to time, and are great. You are using someone else’s money to pay for your vehicle. This is a great use of debt. Although, the way the auto industry works, when these 0% loans are being offered, actual prices on the vehicles are likely higher to compensate. The dealers make money one way or another, so be aware.

Other debt. This last bucket of debt can hold a number of things. A loan for an RV, boat, small business loan, or additional mortgages for rental properties, just to name a few. Just be smart here. An RV or Boat loan is unnecessary. If you are in the accumulation phase of life, you don’t need a boat or an RV, you need to be focused on putting those discretionary funds to work in the market.

Like the mortgage example with Bob above, in the early years, investing as much as possible as SOON as possible is priority number one. If you are already retired and the math works and doesn’t put your nest egg in jeopardy, why not buy an RV?

Small business loans and additional mortgages for rental properties are a different story. Both of these can be beneficial forms of debt, and may accelerate your journey towards financial independence. In both cases, you are essentially using someone else’s money to generate an additional income stream. If you can grow a business, or buy enough properties to grow your cash flow stream high enough to cover your annual spending and annual mortgage/loan re-payments, you just used debt to achieve financial independence. Without a doubt, this is a legit approach and can work. It does come with some risk. Approach with caution and start slow. More on this in Level 2.

Summary:
• Debt can be broken down into five separate buckets. Mortgage, credit cards, student loans, auto loans, and other.
• Mortgage: Don’t pay off early. Keep for the full 30 years, or longer.
              o Accelerating payments will cause you to work longer!
• Credit card: Pay off tomorrow…ASAP.
• Student Loans: Pay off as soon as credit card debt is taken care of.
• Auto Loans: Pay off, or even better, pay cash and buy a used card.
• Other: Stay away from RVs and boats unless you have already hit financial independence; Rental mortgages and small business loans can accelerate your journey, but start small and go from there.

Your Next Steps:
• What debt do you have? Start a basic spreadsheet and tally up all debt accounts and what you owe.
• Prioritize your debt. Credit card first, student loans, auto loans, other, then mortgage, in that order.
• Put together a plan with a timeline of when you will pay off each loan. Start today. Commit to the change.

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