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

critical because too much risk could bankrupt the company and too little debt could leave it vulnerable. Once they've found their formulas, most CFOs keep fairly constant debt ratios from year to year.10 Every corporation in the world uses debt as a tool to fund operations and leverage opportunities, and you and your family should, too.

      WHO NEEDS AN AAA RATING?

      Only two companies in the United States issue AAA bonds.11 AAA bonds mean a company has the highest possible credit rating and generally the least amount of debt.

      Pick a large company you admire, and chances are high that its bonds do not have the highest credit rating. Make no mistake, this is a proactive choice by the CFOs and they are well aware that they do not have the highest rating. These companies could easily choose to be AAA, but they don't see the value in having the highest credit rating.

      They've chosen to embrace the liquidity, flexibility, and tax benefits associated with debt. At the same time, they make sure they don't have too much debt so that they take on too much risk.

      Most Fortune 500 companies find a balanced middle ground between being debt free and having too much debt.

      There's an incredible disconnect between how companies and individuals look at debt: Almost all successful companies use debt as a tool to provide liquidity and a cushion for emergencies and opportunities, but very few individuals and families are even willing to think about this strategy. Individuals and families tend to either have too much debt or want to pay off all of their debt as soon as they can. In our new financial glide path, we'll take a CFO-like approach and work both sides of our balance sheet.

      The Power of Savings

We need to frame questions about debt, savings, and balance against the fact that compounding matters to long-term investment returns. Table 1.1 shows that to retire with $1 million, you can choose to save any of the following:

      ● $360 a month at age 20 (with a total of $194,400 saved and invested);

      ● $700 a month at age 30 (with a total of $294,000 saved and invested);

      ● $1,435 at age 40 (with a total of $430,500 saved and invested);

      ● $3,421 at age 50 (with a total of $615,780 saved and invested); or

      ● $14,261 at age 60 (with a total of $855,660 saved and invested).

Table 1.1 Summary of Savings Rate to Accumulate $1 million by 65

      Assuming a 6-percent rate of return, each of these approaches yields $1 million at age 65. But what's particularly interesting is the person who starts at 20 invests $194,400, or about 77 percent less than the person who starts saving at 60 and invests $855,660. This is the difference compounding makes. And I believe we are so anxious to pay down debt that it can come at a cost of deferring our long-term savings and that this cost is significant when we finally direct money to savings. We do not give our money time to grow for us.

      THE DIFFERENCE COMPOUNDING MAKES

      Jennifer and Josh are both savers and investors. Jennifer starts saving and investing at age 20 and saves $2,000 a year until she's 29 – a total of $20,000. Josh starts saving and investing the same amount, $2,000 a year, when he's 30 and does so until he's 65 – a total of $70,000. They both invest in a diversified portfolio of equities and receive an average 8-percent return over the entire period of time that their money is invested. Who will have more money in retirement at age 65?

      At age 65, Jennifer will have about $463,000; Josh will have about $375,000 – $88,000 less. This is because Jennifer reaped the benefits of earlier compounding.

      Starting early makes an enormous difference!12

      A New Glide Path: Debt Adds Value

      Considering that while we would rather not have debt but that it is often a necessary tool, let's reframe the “Debt is Bad” attitude:

      Debt adds value, and when used in a balanced way, has a positive effect on people's lives.

      Let's test this theory. Imagine there are two households, the Nadas and the Steadys. They live in a magical world with no taxes or inflation, interest rates never change, and investment returns are certain. This world is also magical in that banks will let people borrow however much they want for homes. Let's also imagine the following:

      They both start at 35 years old.

      They start with zero assets.

      They both make $120,000 per year and never make a penny more or a penny less.

      If they invest money they earn a rate of return of 6 percent.

      If they borrow money they can borrow at 3 percent.

      Their house appreciates by a rate of 2 percent per year.

      They both save $15,000 per year ($1,250 per month).

      They never move.

      Imagine they both purchase a house when they are 35 years old for $300,000, 100 percent financed. Therefore, they both have a $300,000 mortgage. With a 30-year amortization, this has a house payment of about $1,250 per month, which is covered from their cash flow, not their savings.

      For how much they have in common, it turns out they do have one big difference between them: Their attitudes about debt. The Nadas want to get rid of it as fast as possible. The Steadys are OK with it as long as they build up their savings. The Nadas direct all of their savings to paying off the house. The Steadys never pay down a penny extra on their house and build up their savings. Let's look at their lives at 65.

      They both have a house worth approximately $550,000. They never intend to move, they have to live somewhere, and they both live in a house of the exact same value so the value of the house isn't relevant.

      The Nadas paid off their house in 142 months, or in a bit under 12 years. They have owned their home free and clear since they were 47. At this point, they redirect their $2,500 per month savings toward retirement. This is their $1,250 former house payment + $1,250 monthly savings (monthly savings = $15,000 per year / 12 months). At retirement, they would own their house and have about $1 million.

      The Nadas followed the traditional glide path with a conventional “Debt is Bad” attitude. But questions remain: Are the Nadas able to accomplish their retirement objectives? Was this plan optimal?

      While $1 million sounds like a lot, they were making $10,000 per month and used to spending $7,500 per month. If they have a 6-percent return on their investments, they will receive a monthly income of about $5,000 per month (6 percent × $1 million / 12). According to conventional wisdom they “did everything right” but will have to take a pay cut of about $2,500 per month.

      The Steadys took a different approach. They made the minimum $1,250 per month payment on their mortgage. They directed the additional $1,250 into savings, which grew to approximately $1,250,000. They paid off their mortgage the day they retired. So they not only own their own house, but have $250,000 more than the Nadas. At 6 percent per year, their income is $75,000, which is $6,250 per month. This is about $1,250 per month better than the Nadas, but $1,250 shy of where they would like to be. Perhaps their expenses change a little so maybe this is all right and maybe the Steadys are OK.

      Let me introduce you to a third family, the Radicals. They are on a new glide path and take an entirely different approach to debt: They never pay it down.

      The Radicals only pay interest on their mortgage, which is $750 per month (3 percent × $300,000 = $9,000 per year, or $750 per month). They take the rest of their money, about $1,750 per month, and contribute it to savings for the same 30-year period. Everybody worries about the Radicals because everybody knows that on the day they retire they have a $300,000 mortgage – but their savings have grown to $1.75 million. On the day they retire, the Radicals could pay off their mortgage

10

This is a central theme of Thomas J. Anderson, The Value of Debt (Hoboken, NJ: John Wiley & Sons, 2013). In particular, Chapter 3 goes into extensive detail on corporate debt ratios. For those who would like detail, see endnote 3 from Chapter 3 of The Value of Debt.

11

Lucinda Shen, “Now There Are Only Two U.S. Companies With the Highest Credit Rating,” Fortune (April 26, 2016), http://fortune.com/2016/04/26/exxonmobil-sp-downgrade-aaa/.