Tom Anderson, Personal Finance Author, The Value of Debt in Retirement: Why Everything You Have Been Told Is Wrong – Guest post – Time to Open Our Minds About Debt by
It has been ingrained in most of our minds for years. Debt is bad. Period. Get rid of it if you want to achieve financial freedom. But I say hold that thought. Not all debt is created equal. And some debt, if used the right way, may actually be beneficial to growing and maintaining your wealth.
Imagine you get back to your desk after a meeting and your voicemail light is on. You missed a call from none other than Tim Cook, the CEO of Apple. His message goes something like this: “You know, the weirdest thing happened. You have inherited all of Apple. You own the company.”
That would be a pretty amazing message to get. It would actually mean you inherited billions of dollars of assets, but guess what else you inherited? Billions of dollars of debt. Debt that they just issued in the past year. But would you still take that offer? If not, feel free to send it my way.
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Passing on debt in itself is not bad as long as there are more assets to offset that debt. If I pass on $15 million of assets and $5 million of debt, you would inherit $10 million. In another scenario, I pass on $5 million of assets with no debt. Which one would you rather have? I would take the first scenario all day long.
Virtually every successful company in the world uses debt…on purpose. They have it because it provides much needed liquidity and flexibility. And that is the centerpiece of what people need to survive, to weather the storms that come along when we least expect it.
In my new book, The Value of Debt in Retirement: Why Everything You Have Been Told Is Wrong, I take a balanced, holistic approach to how the strategic use of debt can potentially increase your return, lower your taxes, and reduce your risk. Our industry is filled with information and ideas about your assets, but that’s only part of the picture. The focus needs to be on both sides of the balance sheet.
It’s important to recognize there are different types of debt. I distinguish debt generally by rate and break it into three categories – oppressive, working, and enriching. Oppressive debt is the high interest rate debt like credit cards and payday loans—almost anything with a rate over 10 percent. You want to pay this debt off as soon as possible. Working debt includes mortgages, student loans, and small business loans. The rates may still not be great, but these are things that help advance your life. It’s debt you can afford, at least for a while. Enriching debt is the debt you could pay off tomorrow, but chose not to, like a line of credit against your portfolio. To get to enriching debt, you need liquidity and you need to get rid of oppressive debt. If your working debt rates are low – four percent or less, you can likely afford to wait on paying that off and start building liquidity.
So how much debt should you have? In my experience, most people have either way too much debt or are completely debt averse. The key is finding the sweet spot or optimal debt ratio. This is your total debt divided by your total assets. I take from the strategies used by companies and make them more conservative for the individual. I feel the optimal debt ratio for an individual is between 15 and 35 percent.
When you look back at 2008, people responded one way by saying, “Debt is bad and I need to get out of it as fast as I can.” Companies responded another way by saying “Never again. I need to be less reliant on banks.” Instead, they began issuing more debt to have more cash and more flexibility. People have rushed in to pay off their house and my concern is the tide will go out at some point. When the tide goes out and you don’t have liquidity, and asset prices are falling all around you, you’re in trouble. If you have money in your savings account and have debt, it will provide you with valuable liquidity when things go bad in your life.
Let’s say you have a $400,000 mortgage and you have $100,000 in cash. You put down $100,000 on that house and two months later, you lose your job. You can’t refinance that house because you don’t have a job anymore. You don’t have the liquidity. You actually could find yourself in a situation where you end up going bankrupt. If you kept the $100,000, you still have debt on that house, but you also have cash to ride out almost any storm that could come your way. You can use that cash to start building up your asset pile, all the while, reducing your risk.
I recognize that a debt strategy is not for everyone. If you have Social Security, a good pension, and need only 3% from your portfolio in your retirement, you probably don’t need debt. But if you need a rate of return of 4% – 6 % or more, debt can prove to be a powerful tool. Before you move forward with any of these strategies, I strongly suggest you consult with your financial advisor.