Debt is an interesting animal. Most of us get into debt because we WANT something we cannot afford. We want a private school education so we borrow $50,000 to learn something we can learn for free on the internet. We want to live a fabulous lifestyle in our 20s so we put everything from fine dining to designer clothes on our credit cards. We want to stop paying rent, so we leverage up 4:1 to own a property that will crush our finances if we need to sell in a down market.
Make no mistake about it. Debt is a manifestation of greed. Which means I’m one greedy bastard! I wanted to live a nicer lifestyle and I wanted to get rich as young as I possibly could. In my 20s and early 30s, the biggest risk I feared was not taking enough risk.
Some of you might be thinking you aren’t greedy for having debt. But deep down, you know what I’m saying is true. Not only are you greedy, you’re impetuous to boot. But don’t be ashamed. If managed properly, greed can often be good when it comes to reaching financial independence sooner.
In this post, I share with you my debt history followed by a debt optimization framework to help you build wealth faster while minimizing the chances of a financial blowup.
A Stroll Down Debt Lane
With everybody in agreement with my debt type rankings, here are some key moments in my life when I could have gotten into debt or actually did get into debt.
College Years 1995 – 1999: I had zero debt because my parents paid the $2,890 annual tuition and $4,470 room and board which I’ve since repaid. I purposefully chose The College of William & Mary over a private school (~$35,000 all-in back then) because I knew that if I couldn’t get a corporate job after graduation, even with a minimum wage job, I’d still be able to reimburse my parents quickly for four years of tuition. Besides, William & Mary is a great school with small class sizes and a beautiful campus. I was humbled they accepted a kid like me because I didn’t do well on my SAT.
NYC 1999 – 2001: I continued to have zero debt because there was nothing to buy and nowhere to go when you are working 70 hours a week. All I wanted to do was save money and sleep with the precious time I had left. The money I did spend going out was usually charged to my credit card which I promptly paid off each month. If I could have afforded to purchase a NYC apartment, I would have gotten into a lot of debt. But with a base salary of $40,000 my first year and $55,000 my second year, I couldn’t afford to buy a closet, let alone a studio.
SF 2003 (debt begins): At the age of 25, I was restless to change my life. I had several hundred thousand in the bank due to a lucky stock pick (VCSY went from $3 to $150 in several months) and aggressive savings. I was *this* close to leaving everything behind and moving back to Honolulu to work on my grandfather’s vegetable farm. Instead, I took on a $435,000 mortgage by purchasing a $580,500 2/2 condo in Pacific Heights. The condo seemed like a no-brainer at the time since it has a dead on park view that in Manhattan would cost well over a million. Overnight, I was reinvigorated to earn more money due to my debt burden.
SF 2005: I took on a $1,288,000 mortgage by purchasing a $1,520,000, 4/3.5 single family home. For some reason, I didn’t fear taking on so much additional debt because I was being outbid on 2/2 and 3/2 condos that were being listed at $1.1M – $1.2M and being sold for $1.3M – $1.4M! For $120,000 more, I was getting an entire single family house in a good neighborhood that had four bedrooms, and three and a half bathrooms. Yes, it was close to a busy street, but it was also the cheapest single family home I could buy in the north side of SF with this type of scale. The listing agent was from out of town and had listed the house during Christmas when many people were away. I smelled opportunity and went all-in with what I had at the time.
SF 2007: I took on a $560,000 mortgage after purchasing a $715,000, 2/2 vacation condo in Squaw Valley, Lake Tahoe. I thought I was getting a deal because the sellers had bought the condo for $820,000 a year and a half earlier. In 2007 I was at the peak of my financial wealth. Little did I know the housing crisis was right around the corner! As a 30 year old, I thought I couldn’t lose. But on paper at least, I lost BIG TIME.
SF 2014: After spending years grinding back all my losses and getting comfortable as an early retiree starting in 2012, I took on a $992,000 mortgage after purchasing a $1,240,000 fixer upper single family home. I was able to do so partly because a 5-year CD expired in early 2014, giving me the 20% downpayment and a 20% cash buffer.
I was again going through a “what should I do with my life moment” and considering whether I should go back to Honolulu to be closer to my parents, when I stumbled upon this house with panoramic ocean views listing for 40% less on a price/sqft basis than my northern SF home. It made no sense the price would trade at such a discount, where everywhere else in the world, ocean view homes trade at a significant premium. I just had to have it. The property was in what I considered to be an “undiscovered” neighborhood that is just now going mainstream.
Total mortgage debt taken out: $3,275,000
Holy crap! That’s a lot of debt to take on by age 37. Taken in isolation, $3.275M is an inordinate amount of money to borrow. But if you compare the debt amount with its associated asset values and my income, the debt figure seems more reasonable.
The total value of my real estate holdings is roughly $6M. Therefore, my debt-to-asset value ratio is roughly 54.5% aka Loan-To-Value (LTV) ratio. Today, many banks require a borrower to put down 20% on a property, thereby giving the borrower a 80% LTV. Thus in this regard, I’m well in the money.
Further, today, I don’t have $3.275M in debt anymore. After checking my mortgage balances on Personal Capital, my mortgage debt is “only” $2,089,550 for an even more reasonable LTV ratio of 34.8%. This means I’ve got about twice the amount of equity as I do debt. Within 20 years, I plan to get my LTV down to 0%, ensuring that I have at least a $6M net worth to pass on to my children estate tax free. Unless they are bad, in which case no soup for them.
The Lake Tahoe Vacation property is worth about $700,000 (54% LTV). The Marina single family home is worth about $2,700,000 (30% LTV). The Golden Gate Heights single family home is worth about $2,000,000 (45% LTV). And the 2/2 Pacific Heights condo I bought for $580,500 in 2003 is worth about $1,000,000 (0% LTV).
Based on my ratios, I’m not that leveraged. It just seems that way given the total dollar amount is relatively large compared to the median debt amounts Americans have.
The Value Of Debt
Here are some reasons why I’m not freaking out about carrying $2M in debt.
1) Nicer living arrangements. Although I recommend living like a pauper between ages 18 – 34 to achieve financial freedom sooner, after four years of crappy living arrangements after college, I had had enough. Since I was 26, I’ve lived in nicer places compared to what I would have rented because I had drawn a line in the sand at spending more than $2,000 a month for rent.
Today, it is rare for a 26 year old to live in his own 2/2 park view condo in Pacific Heights. The same goes for a 28 year old having his own single family home in a nice neighborhood. If I hadn’t bought property, today I’d be super liquid. But I also wouldn’t have been able to live as well I did for ~12 hours a day for the past 14 years.
2) Passive income. My rental properties generate roughly $109,788 in rental income after all expenses and before taxes. Rental property alone can comfortably provide for me and my wife. Unfortunately, it’s not enough to also cover the cost of raising a child in San Francisco comfortably. Hence my hustle to make $200,000+ in passive income.
3) Investment bet. To be able to control $6M in assets for only $2M at a blended interest rate of 2.65% in the cheapest international city in the world is a long-term bet I’m willing to take. Although San Francisco is going through a price softening now, I’m bullish that prices will be higher 10-20 years later.
I’ve been to many major international cities, and San Francisco is good value relative to the jobs and incomes available. For example, Vancouver is even more expensive than San Francisco, yet they don’t have dozens of companies paying new college graduates $100,000+. Nor does Vancouver have the VC and startup ecosystem that helps drive innovation. Besides seeing the data, I know these six figure income levels for 20-somethings to be true because I see the pay stubs of many tenant applicants as a landlord.
4) Perpetual motivation. After experiencing 13 years of overseas living, life is relatively easy in America. If you don’t believe me, take a trip to New Delhi and see what hardship really looks like. You can even go to developed Hong Kong and see how little you get in housing for your money. We’ve got it so good. No wonder most of us speak only one language and are out of shape!
If I had zero debt and $200,000+ in passive income, I’m SURE I’d turn into an aimless trust fund kid who decides to travel the world for a year after only putting in a couple years of work. Instead of publishing 3X a week on average for the past eight years on Financial Samurai, maybe I’d publish once a month instead. Instead of responding to comments and e-mails, perhaps I’d just ignore everyone!
Knowing there’s $2,089,550 in mortgage debt still left to payoff keeps me focused on optimizing my finances. I could have quit building my passive income when it was generating $80,000 – $100,000 a year, but I kept going due to a desire to provide the best possible life for my family.
In a personal finance geeky sort of way, I view my four mortgages as my four kids. One has already graduated from college (paid off in 2015), with three left to nurture for the next 5 – 10 years. I won’t stop optimizing my finances until all the mortgages disappear, and especially when a real life kid comes into the picture.
5) Total income can handle the load. Everything is rational when it comes to finance. When someone proclaims they got into $70,000 of credit card debt and then paid it off in one year, it’s simply because they had a high enough income for credit card companies to grant so much debt and a high enough income to press a button to pay it off quickly.
No bank would have lent me so much money if I didn’t have a high enough income for a long enough period of time. Yes, from 2012-2013, I was vulnerable given I had just retired from Corporate America with a ~70% decline in income. But I still had assets I could get rid of to pay off all debt if worst came to worst. I used my debt as motivation to get back to where I was and beyond.
No More Debt For Me
Despite my reasons for embracing debt, I’m no longer planning on getting into more debt. I’m basically borrowing 10X my passive income, which is way out of line based on a recommended 3X income debt maximum. Yes, I’ve got a healthy online income stream from Financial Samurai due to the 1M+ organic pageviews a month, but such income, like Social Security, cannot be 100% counted upon for the long term.
Nowadays it makes more sense for me to invest in cheaper real estate projects around the country, pay down existing mortgage debt, and try to hoard as much cash as possible. I need to be prepared to survive through the down cycle given my debt level.
I’m mentally preparing for a 20% correction in coastal city home prices, similar to the last downturn. In other words, I expect my property value to decline to $4.8M from $6M, leaving me with a LTV of 41.6% from 34.8%. I also expect to see rental income decline by a similar magnitude to $88,000 from $110,000.
Given my expectations, I’m hustling now to create $1.2M in value and $22,000 in extra passive income before the pain occurs. The main way I plan to make up for such potential loss is by building my online business and generating extra passive income through real estate crowdfunding. With an 8% return, all I need is $275,000 in real estate crowdfunding to earn $22,000. I’ve currently got $260,000 invested so far.
Total Debt Framework For Financial Freedom
We know that debt can help us get what our greedy hearts desire. But too much debt can also ruin our lives. Therefore, my Debt Optimization Framework takes into consideration age, income, asset value, and ability to recover from financial calamity. I’ll be using two ratios: Debt / Income and Debt / Asset Value to provide a guideline by age for an Aggressive, Moderate, or Conservative individual.
The chart is built on the following assumptions:
* Each percentage assumption is the maximum recommendation.
* Interest rates remain relatively low e.g. 2% – 4% on the 10-year bond yield for the next decade.
* Student loan debt does not exceed 100% of annual gross income.
* Debt / Income can’t exceed 500% largely because institutions won’t allow it.
* There should be very little to no automobile or credit card debt after age 30.
* Everyone buys a home between ages 25 – 35 to at least get neutral inflation.
* Nobody has any debt left by age 60.
The more I study the chart, the more I like the idea of being completely debt free by age 45 (Conservative). But that’s because I was so aggressive in taking on debt in my 20s and 30s. Only folks with highly defensible and high growth salaries should consider going the Aggressive route. Otherwise, you may end up bankrupt and alone. If you are unsure, follow the Moderate route.
The ideal scenario is to aggressively take advantage of other people’s money while young, get rich, and then pay back all debt ASAP. If you do this, everyday will feel like you’re living off the house’s money, literally and figuratively. After the age of 40, your appetite for risk will wane, especially if you have dependents. Therefore, take more risks while you’re younger so you have more time to recover if things go wrong.
Used wisely, debt is a great tool to help accelerate financial independence. Once you control a relatively large financial nut for a low price, you can build a small fortune. For example, my $6M property portfolio that costs $53,000 a year in deductible interest to control, will grow to $10M in 20 years if the portfolio grows by just 2.59% a year. Further, all the debt will be paid off by then. That sounds pretty darn good to me as I work on building other parts of my net worth in the meantime.
Readers, what is your current Debt / Income, Debt / Asset Value, and age? See any issues with my Debt Guide? I’m happy to make adjustments. And yes, I could just sell property to reduce debt, but I’m on a sellers strike until selling commissions drop by at least 50%.