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 close to all-time lowslows 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 2018 and beyond.
Even though real estate is usually a sound investment, by no means is it guaranteed to appreciate. What other investments are worth going into debt for, do you think?
Myself, that is student loans.
I took loans my first 2 years of college but was able to cash flow the rest of my college.
I was happy to take on that student loan debt, BUT, even happier to pay it off over 18 months even thought it was amortized over 10 years.
Ouch! I am pretty honest with myself about our student debt load and regret not paying it off sooner, but I wouldn’t call us greedy, stupid, entitled, insecure, or desperate about it. We were caught in the 2008 downturn as well, and recent law school grads found their salaries plummeting and the legal market flooded with out of work attorneys. At best, I will say we were oblivious to the impact of delaying payoff, but certainly not stupid. Sometimes the best of intentions or the smartest decisions can have bad consequences due to circumstances people didn’t anticipate.
Hi Rebecca, I’m focusing on consumer debt when talking about greed, stupidity, entitlement, insecurity and desperation. It’s unfortunate education costs so much money nowadays, but education is so vital as I’m realizing more and more the older I get.
But I would say graduating with $200,000+ in law school debt in 2008 is categorized under the desperation category at least. The 2008-2009 downturn caught everyone by surprise, including myself. I started this site due to the need to connect and slay my demons. I’m sure your debt helped propel you to start your site and focus on paying it down as well.
Our debt has absolutely turned us on to a different way of life! I like living frugally. It’s the living ultra-frugally that’s hard to swallow, but we’ll get through it.
Rental properties are my soft spot – you put down the deposit, the tenant pays the bills and generates the profit.
Great post! I have zero consumer debt and only have the mortgage (which is under water at the moment). I have that frugal mindset, while my husband has the ‘lender’ mindset you wrote about. I work for a corporation, while he runs his own business. It’s been very difficult for me to accept the fact that we need to borrow money in order to make money. I still have to almost argue with myself that what we have are ‘good debt’ and not debt accumulated because of material things.
Hi Jane,
Good job on no consumer debt! Hope this housing recovery continues. Where do you own?
I have no consumer debt…a good amount of student loans which I am not in a rush to pay off at the moment. I’m not using it for financial arbitrage as you did but the interest rates range from 2-4% like yours so I’m not making any extra payments on them. I might be looking to take on a mortgage in the near future so I’m trying to get a downpayment together.
Cool. You will feel great once those loans are paid off though! Student loans just started gnawing at my mind.
I recently refinanced my house to a 5/1 ARM at 3.25%. It was brilliant. I know I can pay it off in 5 if the rate adjusts upward too much. I hate debt… Unless I can clearly arbitrage the leverage for a gain.
I am about to pay off my wife’s car because I have so much cash earning nothing that I hate to be paying 2.9% on a car. The only other debt I’ve taken on was a new AC. I would have paid cash for that but it was 0.00% for two years.. No brainer.
Here’s a real tricky one though. A familial entity just offered a low rate interest only loan to beneficiaries of said entity; the principal to be netted from ultimate distribution to beneficiary. I am extremely tempted to purchase a rental property with that.
Nice job with the refi. I can’t stand car loans.
Be wary of too good to be true family lending and investments!
“Use anthropomorphism” – great piece of advice that I’d never considered from a forced negative angle. Some original thinking, nice!
I have rental property debt as the ROI is pretty tasty on just the rental income. Add any capital gains as a bonus (especially when leveraged) and its pretty darn attractive!
One mistake above in the last poll: $2,500,001 – $2,500,000.
I need to get rid of my mortgage debts. It’s going to take at least 10 years.
At least we dont’ have any consumer debt. I can’t believe all your readers are so well off!
Dang, I went to click EDIT the poll to fix the Asset poll, but ended up clicking DELETE instead! Oh well. The two polls on debt are the focus anyway, but I just added a third poll on total debt / total assets.
Just a heads up, Sam – I got an error message after clicking vote in the last poll.
“Unable To Update Poll Total Votes And Poll Total Voters. Poll ID #10”
My vote was for assets between $500K and $1MM. =)
We’ve tried to be pretty strategic in our use of debt overall, but there are a couple of things that in hindsight we might have been better off for having done differently. But the best thing to do is just learn from them and move on with that knowledge!
Yeah, I deleted it by mistake! Oh well. But I just included a third poll on Total Debt / Total Assets for you to fill out.
Back in college, one of my friends had an old VW bus he called Henrietta.
Your poll questions are good, but I think it would be more useful if you asked a question or two about ratios – what is your percentage of total debt to total assets, and what are your monthly payments as a percentage of monthly net pay. Someone who has $100K of debt and assets of $2 million is in a stronger position than someone with $50K of debt and $250K of assets.
Larry, good suggestion and exactly what I’ve done b/c I accidentally deleted the third poll on Total Assets when I was trying to edit.
Had a car loan, paid it last year, so I’m ‘zero’ with anything debt related. Excellent article though and ideas ;)
Congrats! Must feel great.
We are debt free, including the mortgage. Sometimes I wish we’d invested the funds and tried for arbitrage, but in general I think the move was a good one for us. We invest a lot now and have time to make ground on the opportunity costs.
Not a bad position to be mortgage free at all. Although when we’re in a bull market as we have been for the past several years and hopefully for the next several years, I want to be leveraged to the max. We can just never tell though, hence my net worth diversification.
I love the little rationalizations we use to get into debt. We make up false reasons why we NEED a certain type of car or a certain size of house or whatever else. Then when it comes crashing down, then we realize how stupid we were.
Condo in a hotel. Think the condos that sell in the Four Seasons or St Regis Hotel. Banks think they are riskier because they think owners may require rental income to pay the mortgage and HOAs.
Yes. It’s hassle free for a commission. Positive cash flow vacay property.
I was guilty of spending for greed and insecurity and got into debt for it when I was just out of college. Even though I got a job, I felt that I needed to spend more than I really needed. It was pretty dumb now that I look back. I got so used to saving, esp during the downturn that I always feel a bit guilty when I spend money on myself now.
Really? I never knew that you got into debt outta college. We gotta talk! :)
Sam,
Does a solar loan count as consumer or investment debt. I counted it as consumer otherwise my overall debt is over $1 million because of mortgage debt.
Are you going to split time in Hawaii and SF in the future, or permanently live here?
I would classify it as debt. Debt is debt.
I’ll probably straddle my 3-4 favorite places in the world.
One of the things that is challenging for me is that I have a lot of friends, professional dual income $250k combine income a year types that I hang out with. I’m debt free and FI, and on occasion they ask me for advice. I don’t know whether to be brutally honest about how financial decisions are taking them down the wrong path, or just sort of kick the can down the road and answer with the minimum amount of interaction. One couple still has $40k in student loans (at 36 years of age), car debt, a lease on a brand new car, a 30k settlement against a short sale, who knows what other consumer debt, and just bought a $350k house with 3% down. Hmmm, I love these guys to death, but I cringe at some of the decisions that people make because they are very bright, responsible, and successful people. The reality is in the world we live in, not everybody has the same financial IQ, and debt will always be there for those who just don’t get it.
$350K house on a $250K income ain’t bad at all though, unless their income is different.
I don’t think they are suffering. If they were suffering financially, they’d stop getting into debt.
He who dies with the most debt WINS!
I think a lot of people get into debt simply because they think that whatever they’re doing is the norm. That happens all of the time with people taking on bigger mortgages than they can really afford, and it happens with student loans and credit cards as well. As you say, debt can be a great asset in certain situations, but it’s only an asset if you truly understand what you’re doing, what the benefits are, what your alternatives are, and what risks you face.
Credit card debt just feels stupid to me given where rates are. Other stuff… at least it’s an investment in ones future. Might pay off, might not. At least there is a chance.
I don’t understand how people with high debt and no repayment plan sleep at night. Most of my friends are dual income professional couples with car loans, home loans, student loans, and are seemingly unburdened by it all. Personally, I decided early on that the peace of mind from not feeling overwhelmed by debt outweighs any material possession. I think you highlighted the main reasons why people get stuck in a debt snowball. Leverage makes sense on income producing assets. Otherwise, you’re just signing up for stress and slavery, in my opinion.
I couldn’t agree more…I think people are just wired differently. The funny thing is the guy who lives at the extent of his means, doesn’t save a nickel but then croaks at 60 because of some random event…really he played his cards right. The trick is finding balance, you have to save, spend, and give at a moderate level that makes you happy. Now that I’m over my “hump” financially with no debt, the little stuff really doesn’t get to me like it would before. I think those people who don’t seem stressed, deep down really are but are just sticking their heads in the sand.
Or maybe they have it all figured out?
Because being happy and unstressed is what it’s all about!
Honestly, I think the odds are that you are right…the old saying ignorance is bliss, but maybe the ones that are truly ignorant are the people who sweat this stuff like myself.
But maybe they do have piece of mind mate. Everything is rational.
Started with $109K in debt, we have paid off over $80k in the last 40 months. The end is in sight. We stay motivated by thinking about what we will do with the extra $2k pr month after we are done.
That’s awesome progress! What type of debt was it?
Teachers open the door, but you must enter by yourself.
Hi Sam,
Question for you,
I have student loans of 16k @ 6.8 percent. I’m currently in grad school so most of the interest(about 5k is unsubsidized) is deferred until I graduate. Would you recommend I aggressively pay off the loans or put more money towards my 401k? Currently, I’m contributing 4k towards 401k a year. Thanks
Tough to say at 6.8%. I pay down all debts at 6% or greater before investing b/c that is 2X the current risk free rate.
You must monitor your liquidity position since I assume you don’t have full time income now.
I have only had mortgages and occasional car loans. I usually own my cars for many years (last one 17 years). When I owned income property, I had a lot of mortgages. It is a great way to leverage your down payment and increase income.
What kind of car was the 17 year old one? That is long!
It was a Honda Accord Coupe! I still have a 97 Honda Prius for my wife. It has lower mileage (115K), although I may replace it within the year.
You need a 2014 Porsche 911 Turbo. Live a little!
I love how one of your strategies is to pay off the “most annoying debt first” because don’t we all have that one debt that we can’t wait to get rid of?! For me that was a small student loan that I kept procrastinating to pay and just kept getting bigger. I couldn’t wait to finally cross it off my list once I starting getting serious about paying off my debt.
You’re going to love having no more student loan once you do!
Good to look at the result of the polls. It seems that a large chunk of the people are doing well by having zero debts but there’s an equally large number with a decent amount of debt.
“Pay off your smallest debts first and consolidate your loans into one larger low interest loan if you can.” This is fantastic advice that people do not listen to–start small! You can’t expect to get rid of debt quickly. It’s a process.
I can remember once getting a “You can skip your next car payment” notice from a lender. When they did that, I actually got angry at them and paid it off 8 months earlier than scheduled. That was a very good feeling to get rid of that debt.
That is a lot of debt that you were carrying when you finished school back in 2006. Although 2006 wasn’t that long ago, the situation for current students is even worse. I see this as one of the biggest mistakes of the university systems. At what point does the debt become too much and devalue the value of education?
Great article. That’s a very good advice for those who have been also struggling and making ways in how to pay and limit their debts. I agree with you when it comes to paying down debts. Learning how to quickly pay off personal loans, business loans, and any other kinds of loan can help you save money and reduce stress caused by your debts.
Great article. That’s a very good advice for those who have been also struggling and making ways in how to pay and limit thier debts. I agree with you when it comes to paying down debts. Learning how to quickly pay off personal loans, business loans, and any other kinds of loan can help you save money and reduce stress caused by your debts.