Blog

One of the most fascinating topics that I’ve come across this year in regard to personal finance is the amount of controversy regarding interest rate arbitrage. Now, arbitrage might not be a word that we use very often so I’ll quickly define it here.

The simultaneous purchase and sale of equivalent assets or of the same asset in multiple markets in order to exploit a temporary discrepancy in prices.

Still kind of confusing, right? What I’m getting at here is the common discussion around whether to eliminate low interest rate consumer debt (think 2.5% car loans or 4% home loans) or invest in the stock market (individual stocks or index funds). For those of you Dave Ramsey fans out there, you might find yourself in this dilemma when you reach baby steps 4, 5, and 6. You’ve paid off all your debts except the mortgage (student loans, credit cards, car loans) and now you’re trying to decide what to do with the extra funds.

I know, I know, our fearless leader Dave is very clear on this one. Put 15% in investments and the rest on the mortgage. And I’m actually thrilled that he is clear here. Because it’s torment to try to decide what to do with that extra cash flow after debts are gone. I spent at least 40 hours over the last 2 months researching this topic. I’ve read every Reddit thread and every financial independence blog post I could find. Speaking of, Physician on Fire has a great one on this – Paying Off the Mortgage Early is a Mistake I’ll Never Regret.

Opinions are all over the place. It’s controversial! So, let’s stir it up and get into it! Is interest rate arbitrage worth it? Is it something banks should do and we lowly individuals shouldn’t? Let’s see!

The Logical Stance

This stance argues that low interest rate consumer debt is good debt. And if you can get cars, boats, homes at low interest rates (usually below 4% or so) then you should hold that debt and use the extra cash to invest in the stock market to maximize your net returns. This stance is also known as the “Other People’s Money” stance.

In my day job, I am a software engineer. My coworkers are incredibly black and white/logical people. And when I kick around this discussion topic, they are confused on how it’s even a discussion. Why pay down a 3% mortgage when you can get 10% in the market? You’ve heard it a million times, right? So have I.

It brings me back to my finance courses in college. Borrow at 3% in Europe and lend in the United States at 4% and pocket the 1% spread! That’s risk free profit and you just accomplished interest rate arbitrage! This was literally something we were tested on in our International Finance class.

What Does Dave Have to Say About the Matter?

So what’s the story here? Is there an argument against this stance? The logical, easy math stance? Why does our friend Dave Ramsey laugh in the face of this argument? What does he say when people ask this? Fortunately for you, my lovely reader, I am obsessive enough to have found at least 3 episodes where he has been asked this very question. Here’s his response, “If your home was paid off, would you take a mortgage out on it to invest in the market?” Every caller responds, “Well.. no I guess I wouldn’t want to do that.” So naturally, Dave responds, “Well that’s exactly what you’re doing by holding a mortgage and using extra cash flow to invest instead of reducing your mortgage balance!” He does well with this approach.

Personal finance is not called personal finance because everyone does and should act the same in regard to their finances. It’s called personal finance because it’s personal. We have different perceptions and tolerances of risk, for example. We have different goals, beliefs, and lenses through which we see the world. People who have not experienced serious, long-term financial hardship probably align with this “Logical” stance. But there are plenty of other individuals who feel this approach is wrong. So I’d like to throw out a few thoughts on this and see what sticks.

An Argument Against This Position – Not Equivalent Assets

“The Simultaneous Purchase and Sale of Equivalent Assets…”

For us to view this decision as a logical opportunity to exploit interest rate arbitrage, the underlying assets (residential home and publicly traded equity) would have to be considered “equivalent”. For most, this decision is between paying down the debt on their personal, not for profit or rent home versus paying for a new share of publicly traded equity in a for-profit business.

But my home is an asset. It appreciates and I sell it in the future for a profit!

I think where we get mixed up here is that because we will likely make money from both owning a home and from owning a stock, we see these as “equivalent” assets. They are both appreciating assets.

A residential home is consumed. It’s intention on purchase is to be enjoyed. Lived in. Most of us don’t buy a home with ROI maximization as the top priority. That’s a rental property argument, not a residential home argument. We buy homes that we are excited about living in. The potential ROI is not the primary determining purchasing factor as it is for purchasing stocks. Homes are a consumption decision. Stocks are an investment decision.

Personally, I don’t think our home mortgage costing us 3% and our stock portfolio making us 10% are equivalent assets. Just by their very nature, we purchase them with completely different intentions in mind and their holding cost is quite different too.

Another Argument Against This Position – Cash Flow Squeeze

I think we discount the power of cash flow when we consider this tradeoff. When the goal is “maximize investments and don’t worry about low interest rate debt”, it makes sense on paper but certain situations will make this strategy suck in practice.

Consider the person who goes through a financial hardship. If it’s economic, the stock market might drop 20-30% in a very short time frame making it silly to liquidate investments if you need cash to help with payments. What about losing your job or losing a client? The payments don’t decrease in a recession, they don’t go away.

For me, personally, one of the biggest reasons I err on the conservative side here is that I have less day to day stress when I don’t have payments. If things go bad, it’s okay because when you don’t have payments, you can live on a very small income. Whereas if we were still carrying my car debt and decided to finance a second car, that’s another 1k per month we’d have in car payments alone. Or if we decided to get out of our starter home and trade up, we’d have a mortgage costing us 2k per month or so. My point here is it’s fairly easy to work up to 3,4,5,6k of debt payments a month.

Call me crazy, but there is something magical about not having payments. When you don’t have payments, that 6 month emergency fund becomes pocket change, not a massive chunk of capital. Eliminating low interest rate consumer debt might be sub-optimal on paper, but is it worth a lifetime of higher baseline stress?

The Logical Stance – Wrapping Up

Like I said, I’m extremely logically minded. But I’ve gone the route of the sub-optimal financial decision to eliminate low interest rate consumer debt by making extra payments. I knocked out my 5 year car loan in 3. And am on track to eliminate my 30 year mortgage in 8 years. But regardless of my personal preferences, I think there are two weaknesses for the belief that we have an opportunity to exploit interest rate arbitrage by holding low interest rate consumer debt and investing our free cash flow.

First, I don’t think these are “equivalent” assets nor do I think we treat them as such during the purchasing process. Second, I think that engaging in this strategy surely results in a lifetime of higher baseline stress. Small, unavoidable financial issues like cars breaking down, healthcare bills, taxes become a big deal and take longer to get taken care of. And because we don’t have a ton of cash flow, we are more likely to go into more debt because we can’t knock them out in cash immediately, so we put them on the credit card or apply for 0% financing when the fridge finally craps out. Our jobs feel more critical making us more likely to sit down, shut up, and do what’s expected and not rock the boat.

Debt changes us. It changes how we behave and who we become. And I’m not sure it’s for the better.

I think there’s more to this than a simple math argument. What do you think? What am I missing here?

The Conservative Stance

There are varying degrees of this stance. There’s the, “I will pay off every debt including my mortgage before I invest!” end of the conservative spectrum. This is so conservative that not even Mr. Conservative Personal Finance himself, our friend Dave Ramsey, would approve of this approach.

And there’s also the Dave Ramsey, “Pay off all debt but the house, then invest 15% and use any extra to knock out the mortgage” way which is in the middle.

And on the more aggressive side of the conservative stance, you have those who will split the difference and go half in investments, half on debt or some variation there.

What is the Risk?

The reasoning behind the Conservative Stance is usually attributed to a lower tolerance for risk. But it’s really a difference in perception of risk. By eliminating debt, we eliminate payments. By eliminating payments, we free up cash flow. If it’s true that our income is our greatest wealth building tool, then maximizing our monthly free cash flow is a good thing. (Free cash flow here would be excess money left over after paying all living costs and financial obligations each month.) But again, that comes at the cost (or risk) of delaying our investing either entirely or partially until debt is gone.

But haven’t we all heard the saying, “No risk no reward”? Are we sacrificing long term benefit for the short term satisfaction of eliminating debt? If we want to get ahead in life, don’t we need to accept some risk?

I think risk, without question, is at the core of the dilemma here. Do you want to accept the risk of missing the market bull run during your debt elimination or do you want to accept the risk of having payments during a financial hardship? The icing on top being that all the investments you purchased instead of paying off debt might be available to liquidate, but at a fraction of their recent value.

As I said earlier, people approach this situation differently because people have different past experiences. People who have gone through serious financial hardships are probably taking a more conservative approach and knocking out the payments even if mathematically sub-optimal. Whereas someone who has a super optimistic mindset and high tolerance for risk might see that 7% spread between consumer debt and the stock market returns as a no-brainer.

An Argument Against this Position – Ultra Conservative

I think the wrong approach here would be forfeiting your company match, retirement account contributions, and any kind of investing until you were completely debt free. Often times this argument gets boiled down into a completely black-and-white argument – “Do you invest or pay down debt?” As if it’s always one or the other and no one can do both.

I realize that at some level you have to strip it down to have a clear comparison, but this is a complex issue. As you know, I don’t think the underlying assets are the same. Nor do we make purchasing decisions with the same considerations in mind. So I think seeing this decision as an interest rate arbitrage opportunity is wrong.

I think for this stance to have legs, you must take this approach with balance. Being crazy on either side of the spectrum for this topic is sub optimal. I think you have to do both. Now, how you balance both is going to be a case by case basis, of course. As your consumer debt subsides, you can be more aggressive with more of your free cash flow going towards investments. But if you’re carrying 60k of high interest rate consumer debt, then maybe delaying investing for a year or two is worth getting rid of those debts.

What Does Dave Ramsey Have to Say?

Call me a fanboy, but I think Dave Ramsey knocked it out of the park here with his Baby Steps. I think his recommendations are a solid middle ground with a good optimization for stress reduction and a healthy amount of cash flow risk mitigation. To be honest, I don’t completely follow these. We are on baby steps 4, 5, and 6 (these are usually done simultaneously), and we are investing way more than 15%. We invest about 40% of our income and pay down our mortgage with 20% of our income. But that’s only been possible by following the financial independence principles of living well below our means and achieving a high savings rate.

If you’re wondering what the heck I’m talking about when I say “Financial Independence”, you should read this article.

Wrapping Up the Conservative Stance

So, I don’t really know where I technically fall on this spectrum. Obviously, I’m somewhere in the middle. We are definitely not following the interest rate arbitrage approach as we paid off our car early and are currently putting 20% of our income towards principle on the house (3.125% rate). We don’t like payments. Payments restrict freedom and increase baseline stress for me. It’s a bigger deal when we lose our jobs, when the economy hits the crapper, you name it. With no payments, emergency funds can be lower and cost of living falls down considerably. Then, you can much more easily hit the high savings rates of people in the FI community who are saving 80-90% of their income. I think the ultra conservative stance is just as wrong as the ultra logical stance. I think a balanced approach here is the right approach.

Some people will argue, “You’ll never hear someone say they regretted paying off their house early”. I think that’s a tricky argument because we are all very prone to confirmation bias. Once we make a decision, we tend to believe wholeheartedly that it was the right decision.

Life is hard, why do we make it harder on ourselves by loading up on consumer debt and sprinting to blow up an investment portfolio that can be difficult to manage living off of or liquidating in a crisis?

A Call to Comment

This is one of the most controversial discussions in personal finance. I would LOVE to hear your thoughts on this issue. Where do you fall on the eliminating consumer debt to invest decision? Is this an interest rate arbitrage opportunity? Do you think your background and experiences influence your stance? Is this truly a one size fits all solution? What would your advice be to someone who has extra cash each month wondering how to allocate that cash?