I graduated from business school in 2006 with roughly $55,000 in student loans. Although $55,000 is a lot to pay off, I was already a “debt veteran” by then. What’s another $55,000 in student loans when I was already leveraged over $1 million dollars to buy my first properties in 2003 and early 2005?
I didn’t need to take out student loans, but I decided to conduct some financial arbitrage. The maximum amount one could borrow through a Stafford Loan at the time was $18,500 a school year at an interest rate of 2.75%-4%. I took out the maximum amount at the beginning of each school year to pay for tuition while I received 100% tuition and books reimbursement at the end of each year from my company to reinvest in the markets. 2003-2006 was a time of recovery in the financial markets and I figured I could beat a 2.75%-4% annual return.
Even though the financial services industry was going through retrenchment during the time I attended business school, the S&P 500 was doing quite well (2003 +28%, 2004 +11%, 2005 +5%, 2006 +16%). Even long term CDs were yielding roughly 4% risk-free. The extra $18,500 invested in the stock markets each year did end up growing faster than the cost of debt until a year after I graduated.
I was feeling proud of myself for the financial arbitrage until the 2008-2009 massacre hit. Originally, I was planning to continue holding on to my 2.75% consolidated loans to reinvest in the market. But when the markets got rocked, the loans started feeling like a burden instead of a gift so I wrote a check and paid everything off instead. I was overly focused on making an extra $3,000-$10,000 a year on my arbitrage rather than focus on the big picture of my overall net worth. It feels better to have less debt during times of crisis, however in retrospect, it would been better to lever up even more to buy more stocks!
Debt is the opposite of generating passive income for financial independence. Debtors are helping make someone else’s financial goals a reality while digging themselves further down a dark hole. The only type of debt I like is primary mortgage debt given there’s a good chance the underlying property will appreciate in value over a long enough period and you’ve got to live somewhere. There’s never a financial return for renting. Furthermore, the tax benefits of mortgage debt under $1.1 million dollars is also a nice bonus to have.
In this article I’d like to provide a debt framework that will help you get motivated to get out of debt. But first let’s understand the why.
WHY WE GET INTO DEBT
1) Greed. We want things and we want things now. If we are honest with ourselves, most of us get into debt because we are unwilling to work and save long enough to pay in full for the item or experience. We believe we deserve more than we really do and therefore willfully charge our credit cards up to the gills. Even investors trade on margin because we want even bigger absolute returns until we blow ourselves up.
My greed: Went from a $25,000 position in a gas stock to a $100,000 on margin and ended up losing roughly $25,000 in six months i.e. 100% of my initial equity investment!
2) Stupidity. You’ll be surprised to learn how little debtors understand how lenders make money. The interest rate on credit cards average a whopping 14% compared to borrowing costs of 3% or less for financial institutions. The debt servicing payments in the initial years are entirely all interest so taking out a loan and paying it off early when you could have paid cash might not be ideal. Homebuyers who took out negative amortization loans did not fully understand the magnitude of how much larger their principal and interest rates could grow.
My stupidity: Bought a vacation property that required a condotel mortgage. I didn’t realize condotel mortgages were considered high risk by banks so when the financial crisis hit, banks stopped refinancing condotel mortgages completely. As a result, the condotel property market dried up because nobody could get a loan. I wasn’t able to refinance down this property like other properties with conventional mortgages until I received a free loan modification from BoA almost five years later. Not all mortgages are created equal so do your research!
3) Entitlement. We want what our friends have even if our friends have much more money in the bank. Keeping up with the Joneses is an epidemic that is being propagated by social media. Broke people spend money on things they don’t need to impress people they don’t like. Our sense of entitlement is reaching nosebleed levels.
My entitlement: Took out a $55,000 car loan to buy a $75,000 Mercedes G500 at the age of 25 because I got a raise and a promotion. I was proud that I took a risk of leaving my old firm in NYC to come out to San Francisco where I hardly knew anybody. I ended up selling the car back to the dealer a year later for a $19,000 loss because it couldn’t fit in the garage of the first property I wanted to buy!
4) Desperation. Unfortunately life is not always cherries and ice cream. Medical emergencies happen which can blow through our finances in a nanosecond. In fact, health related reasons is the number one reason for personal bankruptcies in the United States. Everyone needs to get the appropriate amount of affordable health insurance. Please take a look at healthcare.gov for what should be affordable care for those of you making less than $50,000 a year and no more than $94,000 in household income. Besides medical emergencies, losing a job and going without income for a while is also a growing issue. Luckily we have unemployment insurance and a growing safety net of government assistance. But the longer we are unemployed, the harder it is to find a job.
My desperation: Blacked out and banged my face on the tub from too much partying, thoroughly splitting open my upper lip. Thankfully got health insurance which covered everything except for a $25 co-pay otherwise the emergency room bill would have easily cost over $500. I’ve never had a huge medical emergency yet, but the likelihood increases every year that passes. I’ve been unemployed for over 18 months, but I’ve planned for the moment for the past several years through savings, passive income, online income, and negotiating a package.
5) Insecurity. There’s a correlation with insecure people and those who have a heavy amount of consumer debt. We spend money to make us feel better because we don’t fully love ourselves. There’s nothing a little retail therapy won’t cure until the retail therapy gets out of hand.
My insecurity: My $75,000 Glendewagen partly resulted from some insecurity that I felt I was too young and inexperienced to give financial advice to clients 5-25 years my senior. A 20-something year old hasn’t gone through enough economic and stock market cycles to know enough to give advice. All I saw was 1.5 years of a crazy dotcom bull market and several years of pain. The SUV was like a “I have arrived badge.” Damn that car was so sweet.
Conclusion: We get into debt because we are greedy, stupid, entitled, desperate, and insecure people! Sounds mean, but I think we can all be honest with ourselves that I speak the truth. I’ve just showed you five of my own examples that proves the case. Only until we can recognize our deficiencies can we take concrete steps towards eradicating our debt.
HOW TO GET OUT OF DEBT: FIVE MAIN STRATEGIES
1) Pay off debt with the highest interest rates first. Mathematically this strategy makes the most sense because it will save you the most money. If you have $5,000 of revolving credit card debt at 15%, definitely pay down your credit card first before paying down your student loan debt at 6%.
2) Pay down the most annoying debt first. There’s no math involved with strategy, only feeling. You should slay the debt that makes you the most angry, the most annoyed, or the most worried. For me, the most annoying debt is credit card debt so I pay it off every month. The second most annoying debt was my graduate school loan. I didn’t have my car loan long enough because I returned the car back to the dealer after a year and took a bath. Curiously, none of my mortgage debt annoys me given the rates are so low and they provide a tax shield. As soon as mortgage interest deduction goes away, I’ll be more inclined to accelerate principal payments on all rental properties.
3) Pay off debt from smallest to largest. Paying down a large debt amount often feels like chipping away at a mountain; you can hardly tell you’re making a difference. Paying off smaller debts, on the other hand, provides more visible progress and is mathematically much easier to do. Momentum is a powerful tool that will supercharge your personal finances. The victory of paying off one debt will spur you into action to pay off the next debt and so forth.
4) Use anthropomorphism. Anthropomorphism is the attribution of human form or other characteristics to anything other than a human being. For example, part of the reason why I’ve owned my SUV for eight years is because I named him Moose. Moose feels like part of the family to me, and since we don’t sell our family members no matter how bad they become, I will continue to keep Moose until he blows up. On the flip side, consider naming your debt after someone you dislike. Give your debt a personality that you despise. The more you dislike your debt, the more you will want to get rid of it.
5) Constantly envision what your life could be like. It is SAD that the average person has to work 107 days to pay their taxes before earning any money for themselves. This statistic alone makes me never want to work again and aggressively find ways to legally shelter my income. If you have no debt, it’s much easier to be free. You don’t have to do “forced work” anymore. Instead, you can work on things you absolutely enjoy.
My favorite strategy: Pay off your smallest debts first and consolidate your loans into one larger low interest loan if you can.
BE FLEXIBLE IN YOUR DEBT PAYOFF STRATEGIES
None of these debt payoff strategies are mutually exclusive. The perfect scenario is if your smallest debt named after an ex-lover charges the highest interest rate and is also the most annoying. Add on the fact that you’re thinking about your debt while you’re still in the office at 8pm and you will destroy this debt in no time. The key is to choose the strategy that works best for you and stay focused.
Consider using different strategies at different times in your debt payoff journey as well. For example, I’ve got three mortgages left: primary, rental, and vacation/rental. I’m focused on paying off my rental property mortgage first because it is the smallest of the three with an interest rate of 3.35%. I next plan to focus on reluctantly paying off my vacation property with a 30-year mortgage rate at 4.25% because the property doesn’t have that much equity so why throw good money after not such a great asset. I won’t be adding extra principal to a primary mortgage whose interest rate is only 2.625%. As long as I’m in the 25% federal tax bracket or higher, its more optimal to receive a tax shield and investment my disposable income elsewhere.
During your debt payoff journey, always keep assessing your current and upcoming liquidity situation. Ask yourself whether you’re up for a promotion, a pay raise, or demotion. Assess the financial markets. Bake in large upcoming expenses. Being in a cash crunch is often times worse than being in debt.
USE DEBT TO YOUR ADVANTAGE FOR FINANCIAL INDEPENDENCE
A great number of people have used debt to enrich themselves beyond their wildest dreams. Just look at the leverage buyouts (LBOs) in the 1980s such as when KKR took over RJR Nabisco with debt and made a fortune once the company re-listed. Observe the countless real estate tycoons from all over the world who smartly took on debt to develop large scale property projects. This is why I encourage everyone to build their investment acumen and move beyond the mindset of frugality.
If you’re one of the millions of consumers taking on debt to buy things that are guaranteed to depreciate, you are likely never going to achieve financial independence. You can’t even imagine building passive income streams as consumer debt keeps you a slave to society.
Consider making a commitment to no longer buy things you don’t need or spend money on experiences you don’t deserve yet. Just think about all the people or institutions who are getting rich off your back. Each debt I’ve paid off made me feel happier and more free due to progress. I’m sure you will feel the same way as well. Take back your freedom and start thinking like a lender instead of a borrower.
Here are two more anonymous polls to participate in to see where you stand in terms of consumer debt, total debt, and total assets compared to other readers. The questions will get you to think about your entire financial picture and where you want to be. I know it’s helped me recalibrate my finances a little today.
RECOMMENDATIONS TO BUILD WEALTH
* Refinance Your Student Loans: SoFi is one of the leading new financial technology companies based in Silicon Valley that not only reviews your credit score and income/debt ratios, but also looks at the quality of your education and quality of your work institution. If you’re right out of school, you’ve got a lot of upside, but perhaps your finances don’t look so great at the moment. That’s where SoFi can really offer lower rates because banks and government lenders can’t look at individuals holistically. Check SoFi out for a lower interest rate.
* Shop Around For A Mortgage: LendingTree Mortgage offers some of the lowest refinance rates today because they have a huge network of lenders to pull from. If you’re looking to buy a new home, get a HELOC, or refinance your existing mortgage, consider using LendingTree to get multiple offer comparisons in a matter of minutes. Interest rates are back down to ALL-TIME lows due to tremendous volatility and uncertainty in the markets. When banks compete, you win.
* Manage Your Finances In One Place: One of the best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize your money. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances on an Excel spreadsheet. Now, I can just log into Personal Capital to see how all my accounts are doing, including my net worth. I can also see how much I’m spending and saving every month through their cash flow tool.
A great feature is their Portfolio Fee Analyzer, which runs your investment portfolio(s) through its software in a click of a button to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was hemorrhaging! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up.
Finally, they recently launched their amazing Retirement Planning Calculator that pulls in your real data and runs a Monte Carlo simulation to give you deep insights into your financial future. Personal Capital is free, and less than one minute to sign up. It’s one of the most valuable tools I’ve found to help achieve financial freedom.
Updated for 2017 and beyond.