The Value of Debt in Building Wealth. Thomas J. Anderson

You should be debt free when you retire.

      ● Debt creates anxiety, stress, and pressure.

      ● Having debt causes you to “waste money on interest.”

      ● All things equal, you would rather not have debt.

      ● Debt increases risk in your life.

      ● Being debt free is less risky than having debt.

      I'm going to prove to you that this is not true. Together, we're going to rid ourselves of the anti-debt hysteria and explore a better, balanced way.

      In a Perfect World, No Debt! But Our World Isn't Perfect

      Debt is risky, and, in a perfect world, we would all rather avoid risk. The problem is that we do not live in a perfect world.

      In their Nobel Prize–winning economic theorem, Franco Modigliani and Merton Miller hypothesize that capital structure (how much debt a company has) doesn't matter in a perfect world, but we don't live in one.2 In our imperfect world, how much debt companies carry matters quite a bit. Companies carry debt because it works for their bottom line even though they likely have the resources or could raise money to pay for things in cash.

      People, on the other hand, do not have this luxury. Our ability to buy things is limited to our income, assets, and use of debt. No one would need debt if we could rent everything we want and need, under terms and conditions we find desirable, and at a cost equal to what it would cost to borrow money to buy. In this perfect world, most people would be neutral to renting versus buying – and renting would often make more sense.3 You don't buy a car and house for a one-week vacation in Hawaii. You rent because the terms and conditions are much better than buying. This same concept could apply to everything in your life, but it doesn't for a combination of financial and emotional reasons.

      In our imperfect world, many people use debt to buy things they could not otherwise afford with cash they have on hand, including houses, cars, education, or investing in their small business.4 As a result, many – if not most – people choose to take on debt early in life and spend their lives trying to pay it down. Is this a good strategy? Should people borrow money? If so, how much should they borrow? How fast should it be paid down? How does buying compare to the alternatives?

      HOUSTON – WE HAVE A PROBLEM!

      The vast majority of us use debt as a tool at some point in our lives and race to pay it off because we perceive it adds little to no value and adds stress to our lives. At the same time, most people desire to ultimately retire, yet are not on track for retirement. Is it possible that we can find balance in this tug of war between paying off debt and being on track for retirement?

      A survey of college graduates who make more than $50,000 per year indicates:5

      ● 93 percent plan to retire by age 75 (and 86 percent before age 70).

      ● 85 percent of those surveyed either have debt or plan to use debt at some point in their life.

      ● 93 percent want to retire debt free.

      ● Only 27 percent think it is even possible that having debt in retirement is a good idea.

      ● 73 percent say that debt increases stress.

      ● 96 percent would choose to not have debt if they had the choice.

      ● 50 percent do not feel on track for retirement, and studies indicate that as many as 90 percent of Americans fail tests for meeting future retirement needs.6

      You Owe a Debt to Your Future Self

      Whether or not debt is bad or debt is good depends on your resources relative to your needs. If you can afford to pay cash for something, then paying cash might be a great idea. But whether or not you can afford it is just one part of a much bigger picture: If you want to retire, you owe a debt to your future self.

      If you are 100 percent confident that retirement isn't an issue for you, then you have a lot of flexibility and could consider the potential benefits of paying cash for everything. However, most of us have to work and save in order to retire. I, for one, do not have enough money to retire tomorrow with the lifestyle I would like to live. For those of us in this situation, we have a dual mandate – we need to reduce our debt and save for retirement.

      If you are like me, you want to enjoy the journey along the way, too. I want to see the world and live in a house big enough to host parties. I'm happiest by a campfire and I don't need anything extravagant, but I like doing some crazy things from time to time. If we want to also enjoy life, it's actually a tri-mandate!

      Around most kitchen tables, a conversation begins whenever extra money comes in (perhaps a bonus or a raise). Should we pay down debt? Should we buy that thing we've had our eye on? Should we save toward retirement? Should that savings be in our retirement plan or in our investment account? And if we invest it, what should it be invested in? Maybe we should get that new house after all.

      I've studied finance my entire life. There are about a million articles telling me how to invest my money, predicting the future (and generally being wrong), and feeding me financial news 24/7. Why do I feel like we are always guessing on these important decisions? What about my debt? How much should I have, and how should it be structured? Why does everybody tell me to get rid of it? I only have so much money; if debt is bad how do I handle my tri-mandate of saving, enjoying life, and paying down debt?

      So how can I be responsible, have the things I want, enjoy life, yet save toward the future, be on track to retire, reduce anxiety, and increase flexibility? I value flexibility and hate being trapped; I want freedom. Will being debt free give me freedom? Or is there another way?

      Break the Paycheck-to-Paycheck Cycle

      Money flows into every household like water through a hose. When all is well, it flows freely and abundantly. But a kink in the hose (loss of a job, a serious medical condition, even a natural disaster) could stop the flow. If you haven't been storing water in cisterns, you and your family will be parched and in peril.

      Too many Americans are in exactly that position. According to one survey, 76 percent of Americans live paycheck to paycheck, fewer than one in four has enough money saved to cover at least six months of expenses, and 27 percent have no savings at all.7 A separate survey found that 46 percent of Americans have less than $800 in savings.8 The estimated collective savings gap for working households 25–64 is estimated to be between $6.8 trillion and $14 trillion. Two-thirds of working households age 55 to 64 have not saved more than one year's worth of salary.9 The well is not deep enough to sustain them through a crisis.

      Is it possible the conventional wisdom that debt is bad has contributed to our savings gap? I believe our anti-debt mentality is contributing to the fact that we are dramatically under saved and ill prepared for crisis. I believe it's time to consider a new glide path and to break this cycle.

      I believe there is a better, balanced, and simple way to accumulate wealth by using both sides of your balance sheet – your assets and your debts.

      Companies Embrace Balance

      Every successful company in the world has a chief financial officer (CFO) who looks holistically at the company's finances to maximize resources and profits. You and your family are not a company, and I understand that there are important differences. But a CFO's raison d'être is to do well financially, and we can learn some important, broad lessons from CFOs as we establish our personal, financial glide path. I believe one of the important tips we can take from CFOs is how they work both sides of the balance sheet to design and implement an overall debt philosophy and establish lines of credit as part of a holistic picture.

      Structuring the right

2

See the concepts of weighted average cost of capital and the Modigliani-Miller Theorem: F. Modigliani and M. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review 48, no. 3 (1958); F. Modigliani and M. Miller, “Corporate Income Taxes and the Cost of Capital: A Correction,” American Economic Review 53, no. 3 (1963).

3

This is not an impossibility. For example, if housing is a great investment that maintains its value after depreciation, then investors should be willing to buy houses and rent them at a low rate to consumers, capturing not only the rental income, but also the appreciation of the asset as their total return. Rental rates could in fact be lower than purchasing rates. This in fact happens in many markets today, within and outside of housing.

4

Note that many consumers' desire to own is not limited to assets that we perceive to be likely to go up in value over time. Consumers also want to own items that are more likely to go down in value such as cars, boats, clothing, and intangible assets such as education (which theoretically leads to higher productivity and wages, a positive trade-off, or better future opportunity).

5

Results based on survey conducted by Supernova Companies in December 2015. The survey featured 394 respondents who met the following criteria: age 21–60, minimum of college degree, and annual income of at least $50,000. Full results are available here: https://www.surveymonkey.com/results/SM-KCDY3XGJ/.

6

Nari Rhee, “The Retirement Crisis: Is it Worse than We Think?” National Institute on Retirement Security (June 2013). http://www.nirsonline.org/storage/nirs/documents/Retirement%20Savings%2 °Crisis/retirementsavingscrisis_final.pdf.

7

Angela Johnson, “76 % of Americans are living paycheck-to-paycheck.” CNN Money (June 24, 2013). http://money.cnn.com/2013/06/24/pf/emergency-savings/.

8

Ibid.

9

Rhee, “The Retirement Crisis.”