personal debt and credit scores

I’m very interested to hear how you CFAs and candidates look at debt. Do you look at it from a purely financial and mechanical perspective or is there a lifestyle and emotional component to your decision making?

Pretend that you own real estate with an asset value of $2.0 million (personal residence plus rental property) and have $1.0M in combined mortgages, with an average of 4% interest rate. Your uncle dies and leaves you $1,200,000 in pure cash. Do you

A) Run to the bank and pay off all the debt before you have a chance to piss it away on vacations, cars, and strippers?

B) Invest this new-found cash, knowing it may grow big or vanish because the cost of capital is lower than expected ROI, thus leading to positive NPV?

One option offers big upside, the other offers pillow comfort. How would you approach this decision if it happened tomorrow?

Also, does anyone here have an 800 credit score, or something that would get you those super low mortgage rates?

B. Mortgage interest is the only good interest you can deduct on your annual tax return.

I will add if it were me, I’d likely use a chunk of the proceeds against principle to expedite the final payoff date.

In true BSD fashion, i would go to the nearest casino, walk up to the roulette table, and put it all on 0-00 (green).

It depends what kind of prospects you have and what type of personality biases you exhibit.

Personally, I would probably invest the proceeds, hoping to earn at least the interest cost on my mortgage. It’s like refinancing long term assets for working capital.

Probably a mix…

I might use part of it to try and take out the mortgage with the highest interest rate, and then re-invest the rest.

A) Having as little debt as possible gives you the freedom to do as you please. The coupon payments on debt keep you in your desk chair. As discussed in another thread, I’ve been aggressive at reducing debt, probably at the determent of savings of course. However, I can easily fund my lifestyle working at SBUX if I had to. Reduces the stress. And while many folks claim they borrow to invest, many North Americans are in way over their heads on that premise. Also - Interest is not tax deductible in Canada, which may be a driver behind my view. Tax free guaranteed 3% return? Done! I don’t know my credit score but I imagine its very high. I always get way below posted rates. Then again my interest coverage is 8-10x including my mortgage.

At your compensation level, the deductability of interest is severely impaired.

Deductions don’t go away completely, they just start to phase out at $300k for married, $250k for single. And the phase-out is pretty slow. EG - I have a tax return of a guy who has AGI of $1.2 million, but he still gets to take about 63% of his deductions.

Student loan interest, however, is a different animal. You don’t have to itemize deductions to get it, but it starts to phase out at $130k married ($65k single) and is completely phased out at $160k ($80k single). So strictly from a tax standpoint, student loan interest is worse than mortgage interest.

Good news/bad news - when you die, your student loans die with you. So don’t be in too much of a rush to pay them off, if you have a high balance and a low interest rate.

^ I was thinking of the impact of AMT.

I loved my tax class until I found out this existed. Then I realized tax accounting really made no sense.

I try to reduce debt to zero. My goal at the end of 2015 is to be debt free except for mortgage and by 2018 I’d like to be entirely debt free and beholden to no man. In my experience, the size of the house and the the happiness it contains are not related.

If i won $150M in the powerball, I’d buy a $500k house (primarily land value) near Ohiopyle, PA and live out my days in the outdoors. Over time I would develop a plan for giving a significant portion of the remainder to quality causes.

I work with a guy who has the same view. Just refi’d his house to a 15 year to knock it out. I haven’t been terribly agressive about paying down the note on my house because I don’t plan to live there for a super long time (probably max 5-7 yrs). The tax deductability isn’t as big of a deal as I expected because of the relatively small mortgage balance, which I could pay off pretty quickly if I really wanted to. I’d rather have the financial flexibility of more cash and investments rather than equity in a house. I love the fact that I easily have 2 years, maybe 2.5, of living expenses in the bank and taxable investments.

My mortgage is 3.5% on a 30 year fixed, but I refi’d in May 2013. I have pretty good credit, but not 800. It’s good enough.

I wouldn’t choose A or B. I would sell my $2m in RE and take my $2.2m in cash (net of mortgage) and either buy a cheaper house (depending on RE prices at the time) or rent and invest it all.

Sounds similar to my Powerball plan.

If your debt is at 4% and you are able to maintain interest payments, there may be better options out there.

If you have credit card debt at 15% or 20% or something like that… paying down that debt is an awesome investment. Where else in the world today are you going to find something with a pretty much guaranteed IRR of 15-20%. The downside is that the profits are limited by your current balance, so the NPV may be small compared to your windfall.

In my worldview, debt is useful for a few things:

  1. financing fixed investments for productive activities that have an expected return higher than the interest rate plus a margin of safety

  2. creating financial leverage after having made a carefully considered decision on how much risk you can afford to take (and are willing to take).

  3. financing consumption decisions that you have already budgeted how to pay back. (basically bridging short-term mismatches between the timing of income and expenses)

  4. financing emergencies (hospital bills, etc.), unemployment after savings has run out. This last one is not really “recommended”, but sometimes people are left with no other choices: die today, or die in a few months with extra debt…

Perhaps I’ve forgotten something else, but that pretty much covers the only cases where you should go into debt.

The key here is to ask yourself whether going into debt is a decision motivated by consumption or investment (especially physical capital).

Debt as a tool for consumption is dangerous and suspect, except in the case where you have mismatches between income and expenses (i.e. liquidity management). The risk there is that one is not sufficiently realistic about future ability to pay. It’s easy after a small windfall to spend it mentally on two or three different things, only to discover the windfall put you further in debt.

Debt as a tool for productive investments is more justifiable, although one needs to be conservative and realistic about how big the expected returns are, and what kind of risks you face and how you will manage if those expected returns don’t actually materialize. However, debt as a tool for acquiring the capital you need for income-producing activities or a business is much more defensible.

As for windfalls, there is (I’m told) an old Jewish rule of thumb that with a windfall, you spend a third, save a third, and invest a third.

^What’s the difference between saving a third and investing a third?

I’d be debt-free if I could sell my damn “investment” property.

^ Is that your timeshare?

I didn’t invent the proverb, I just quoted it.

I think the proverb comes from a time when “investment” meant “put it into your business,” and “savings” meant “save it for a rainy day or nest egg.”

Today, when investing has more of a financial meaning than a business meaning, the line between investing and savings is blurrier, since both start to look like nothing more than account number and a balance.

However, there is still a distinction between savings and investing, since one is low-risk/low-return (savings) and the other involves seeking higher returns at the cost of higher risks. In the tech bubble, many people didn’t distinguish between savings and investing and so found that they had thought they were saving, but had actually put their entire savings into the stock market, because “the market always goes up, and way faster than savings accounts.”

Let me clarify that I said 2M in real estate allows for your scenario already

In this scenario, I was thinking of a 300k personal residence and 4-6 rental properties in addition