The right asset-to-liability ratio is important if you want to retire comfortably. If your ratio is too low, you may stress too much about your finances. If your ratio is too high, you might not be taking enough advantage of cheap debt to get richer.
As interest rates decline and stay close to zero, the propensity to take on more debt increases. Low interest rates also encourages more investment. This can be good for economic activity, but it can also create asset bubbles that end up destroying a lot of wealth. Be careful.
On the corporate finance side, companies are taking on more debt to fund operations, investments, and acquisitions. The hope is that the return from various corporate activities will surpass the cost of debt in order to bring even more wealth to shareholders.
On the government side, the Treasury Department is issuing more Treasury bonds to pay for more government spending. It is logical to conclude that tax hikes are on the horizon. Luckily for us, the U.S. government can also print an unlimited amount of money to in essence pay back the debt.
On the personal finance side, consumers are taking on more debt to live a better life today. Below is a chart of my favorite type of debt, mortgage debt. Mortgage debt is the least bad type of debt because it generally improves the quality of your life and can often help build wealth through an appreciating asset.
As mortgage interest rates drop to record-lows, millions of Americans are smartly refinancing their existing mortgages to increase cash flow. Meanwhile, there’s a growing number of Americans buying new homes to live a better life.
How Much Debt Is Too Much?
With interest rates collapsing, the risk is that corporations, the government, and consumers take on too much debt. Too much debt brings down entire economies.
Nobody wants to invest in a company where a couple of bad quarters could lead to bankruptcy. If a government has too much debt, not only is there a greater chance that tax rates might go up, but inflation might also surge due to too much monetary stimulus.
But what I really care about is how much debt is too much on the personal finance side. We can’t control what overpaid CEOs of public companies or power-hungry politicians do. We can only control ourselves.
Focus On Percentages As Well As Debt Amounts
Being a million dollars in debt may sound terrifying, but it all depends on your overall net worth. Therefore, it’s important to focus on debt as a percent of assets or overall net worth.
Let’s say you meet someone with $2 million in liabilities. You might think that person is doomed to work forever since the amount is so large and the risk-free rate has collapsed. However, we must also understand the person’s asset level.
Despite having $2 million in debt, this person also has $10 million in assets. His assets generate over $200,000 a year (2%) in income, easily covering the $50,000 a year in liability costs (2.5%). This person has an asset-to-liability ratio of 5:1.
In other words, with a net worth of $8 million, this person is fiscally sound. His assets would have to decline by 80% before he can no longer liquidate his assets to cover his liabilities.
If this person had an asset-to-liability ratio of 100:1, but only had $100,000 in assets and $1,000 in liabilities at age 40, that’s not very good. It is likely the person failed to appropriately use debt to boost his wealth for the past 20 years.
Let’s discuss what may be the appropriate asset-to-liability ratio for various age groups. The ultimate goal is to leverage cheap debt to improve the quality of your life and maximize your wealth creation without taking on excess risk.
This exercise should help you review your net worth and come up with a plan to get to the ideal ratio.
The Right Asset-To-Liability Ratio
Not all assets are created equal. Some appreciate faster than others. Some depreciate. My hope is that readers can accumulate assets that have historically appreciated over time: stocks, bonds, land, real estate, fine art, commodities, antique cars, rare coins, and so forth.
Not all liabilities (debt) are created equal either. Credit card debt and payday loans are the worst. Stay away. Personal loans are an alternative because interest rates are often lower than credit card interest rates. However, personal loan rates are much higher than student loan and mortgage rates and should mainly be used to consolidate more expensive debt.
Ideally, the main types of debt we should focus on are mortgage debt, student loan debt, and business loan debt. These three debt types are tied to assets. Whereas all other debt types are not and should, therefore, not be carried or eliminated ASAP.
With the understanding that there are various types of assets and liabilities, let’s go through a rational framework to determine the right asset-to-liability ratio by age.
Your 20s: Little Assets, Perhaps Lots Of Debt
Unfortunately, our 20s are often encumbered by student loan debt and consumer debt. Not a lot of time has passed yet to accumulate wealth. As a result, it’s common to see liabilities greater than assets, i.e., negative net worth.
For those who are fortunate enough to have no student debt or personal debt, then you can probably accumulate an artificially high asset-to-liability ratio simply by saving and investing your money.
But remember, a high ratio might not mean much if you don’t have a lot of assets in the first place, e.g., 20:1 ratio, $20,000 in investments and $1,000 in credit card debt.
Therefore, it’s good to also have a net worth guide by age target, together with a target asset-to-liability ratio. Below is a review of various net worth targets by age based on a multiple of earnings. The net worth multiple targets can be considered stretch targets.
For example, by age 30, you should strive to have a net worth of 2X your annual gross income. If you are making $100,000 a year at 30, then your goal is to have a $200,000 net worth or greater.
A reasonable target asset-to-liability ratio by 30 is somewhere between 2:1 to 3:1. In the above scenario, a person with a $200,000 net worth may have assets of $400,000 – $600,000 and liabilities of $200,000.
With plenty of working years ahead, people shouldn’t be afraid of taking on mortgage debt or have student loan debt. After all, one of the reasons why we’re working is to find a nicer place to shelter. In our 20s, we more easily have the ability to work through our debt.
Your 30s: More Assets, Still Lots Of Debt
By the time you turn 30, you should have a clear idea of what you want to do with your life or where you want to go.
If you haven’t bought a primary residence by 30 yet, this is the decade to get neutral real estate. If you put a standard 20% down payment, you get to control an asset worth 5X more. So long as you follow my 30/30/3 home buying rule, most of the time you should be fine.
By age 35, strive to have a net worth of 5X your annual gross income. By age 40, shoot to have a net worth equal to 10X your annual gross income.
Another good goal to have by age 40 is to have paid off all liabilities except for your mortgage. If you can also pay off your mortgage by 40, then great. But this is rare since the median homebuyer age is now about 33.
Let’s say you’re earning $100,000 a year at age 40. Hopefully, you will have accumulated a net worth of about $1 million through aggressive saving and investing after 18-22 years post high school or college.
A fair target asset-to-liability ratio by 40 is between 3:1 to 5:1. For example, a $1 million net worth could be comprised of $1.5 million in assets and $500,000 in liability.
Your 40s and 50s: More Assets, Hopefully Way Less Debt
Depending on whether you want to keep accumulating assets using debt, your 40s should be a decade where you’ve been able to accumulate a hefty amount of savings and investments. Your earnings power is generally the strongest during your 40s and 50s as well.
With greater earnings power sometimes comes the temptation to take more risk. However, I’ve seen plenty of people in their 40s and 50s get let go for younger, cheaper employees. Therefore, you don’t want to take on too much additional debt, especially if you have dependents.
Controlling lifestyle inflation is important. After 20 years of work, if you survive multiple rounds of layoffs, you’re probably feeling a little burned out. This is where building up a significant taxable investment portfolio can really help your psyche.
By 50, a good net worth target to have is 15X your annual gross income. Therefore, if you still make $100,000 a year, your goal should be to have a $1.5 million net worth.
By 50, strive to have a target asset-to-liability ratio of between 5:1 to 10:1. For example, if you have a $1.5 million net worth, it may be comprised of $2 million in assets and just $300,000 worth of mortgage debt.
At this stage in life, you’re no longer afraid of debt because your income and assets are significant. You’re used to using debt to build wealth and create a better life. At the same time, you’re also focused on completely eliminating all debt.
Your 60s and beyond: Big Assets, Little-To-No Debt
By the time you’ve reached your 60s, it’s a good idea to be debt-free. This is especially true if you no longer work, haven’t built enough passive income streams, or barely have enough coming in from Social Security to survive.
But if all goes well, by 60, you will have accumulated a net worth equal to 20X your annual gross income. 20X annual gross income is my baseline net worth target before you will start truly feeling financially independent. Therefore, if you make $100,000 at 60, hopefully, you will have accumulated a $2 million net worth.
By age 60, your goal is to have an asset-to-liability ratio of 10:1. With such a ratio, it would take a 90% decline in your assets before you can no longer liquidate to cover your liabilities. Of course, if you are debt-free (infinity ratio) with a livable retirement income stream, you’ve got nothing to worry about.
If you do get to age 60 with a net worth equal to 20X your household income, you don’t want to robotically start following a four percent withdrawal rate since we don’t live in the 1990s. Start withdrawing more conservatively and see how things go. Build some supplemental retirement income through your interests. You could get unlucky and retire into a bear market.
The Ideal Asset-To-Liability Ratio By Age Range
Below is a handy guide that highlights a suggested minimum asset-to-liability ratio and target net worth by age group. The target net worth by age assumes someone or a household is making between $125,000 – $300,000 over their working careers. The target asset-to-liability ratio is independent of income.
After going through this exercise, to retire comfortably, I think the ideal steady-state asset-to-liability ratio is 5:1 or greater for the majority of people.
With five times more in assets, you’re in a fiscally sound position to weather most economic downturns. Hopefully, your liability mostly consists of “good debt,” like a mortgage or any type of debt to fund a potentially appreciating asset. With liabilities equal to 20% of your assets, you have enough leverage to give your net growth a boost during good times.
If your liabilities consist of credit card debt, you’re shooting yourself in the face given the high interest rates and lack of a corresponding appreciable asset. At least there are new consumer loan companies like Credible that is able to offer significantly lower personal loan rates to help people consolidate their debt.
Calculate Your Asset-To-Liability Ratio
Take a moment and calculate your asset-to-liability ratio. You can do so by hand or by using a free financial tool to automatically tracks your assets, liabilities, and net worth for you.
Calculating your asset-to-liability ratio will likely motivate you to at least pay down some debt to increase your ratio. If you find your ratio above 5:1, depending on age, you might also consider leveraging cheap debt to potentially build more wealth or improve the quality of your life.
Once you get to an asset-to-liability ratio of 10:1 or greater, your debt might start feeling like a nuisance. If you’ve got a significant amount of assets, the desire to take on more debt may decrease since you have already won the game or are very close. Therefore, you might simply make it your mission to become debt-free.
With mortgage rates so cheap, my goal is to leverage up and buy a larger and nicer home. We’ve got an asset-to-liability ratio of around 15:1 and are comfortable bringing it down to 7:1 to improve the quality of our lives. If we do, we’ll then refocus on paying down debt given we’ll have little-to-no control over our passive investments.
Before taking on any debt, always think about how the debt can make your household wealthier and/or happier. If you do, you will build your net worth more wisely.
Remember, the goal is to not have the largest net worth. Your goal is to utilize wealth to provide the best lifestyle possible. If you’re living your best life, you are truly rich, no matter the size of your net worth.
Recommendation To Build Your Wealth
Track your finances. The best way to build wealth is to get a handle on your finances by signing up with Personal Capital. Is is a free online tool which aggregates all your financial accounts on their Dashboard. This way, you can see where you can optimize.
Before Personal Capital, I had to log into eight different systems to track 28 different accounts. Now, I can just log into Personal Capital to see how my finances are doing. Simple!
One of their best tools is the 401K Fee Analyzer. It has helped me save over $1,700 in annual portfolio fees I had no idea I was paying. Their Investment Checkup tool is also great. It graphically shows whether your investment portfolios are property allocated based on your risk profile.
Finally, utilize their Retirement Planning Calculator. It uses real data to come up with various financial scenarios based on Monte Carlo simulations. You can input multiple expenses to come up with as realistic an assessment of your finances as possible.
Lower your debt burden. Take advantage of record-low mortgage rates by refinancing your mortgage. For free quotes from qualified lenders, take a look at Credible, one of the leading lending market places today. When banks compete, you win.
Readers, what is your asset-to-liability ratio? What is your ideal asset-to-liability ratio? Are you feeling the temptation to take on more debt given interest rates are so low?