One of the reasons why I want to rebuild my cash reserves back over $100,000 is because of financial risk. With two rental mortgages to pay and no steady job, having less than $100,000 feels irresponsible. Theoretically, I could lose all my tenants and therefore have to shoulder both mortgage payments on my own. In such a scenario, because of property taxes, an HOA fee, maintenance, and mortgage payments, $100,000 would be exhausted in 12 months.
Going off a gut feeling to determine how much cash to have is OK. But it would be nice to formalize a debt-to-cash scale to see at what level debt is too much. Because of excessive debt, way too many people got their heads blown off during the last financial crisis. Today, we once again see plenty of people borrowing from their home equity to buy things they don’t need. It’s so funny how quickly we forget about the risk of having too much debt!
THE NECESSITY OF DEBT TO BUILD WEALTH
The only reason why I take on debt is to leverage up on potentially appreciating assets like San Francisco real estate. So far, so good as the labor market is robust in the Bay Area, and the bubble in tech hasn’t popped, yet. Remember, despite the dotcom meltdown and financial crisis, rents still went up.
I will never knowingly take on debt to buy a depreciating asset. Neither should you. Because of the interest you must pay, to do so is like giving yourself a double uppercut.
In event of a bad investment or downturn in the economy, too much debt can crush your finances. This post will discuss what levels I think are simply too much.
Cash is used as the denominator so we can measure financial risk. It’s all fine and dandy to have equity as the denominator, but when shit hits the fan, your equity could disappear in a nanosecond. Having cash is the true safety net. Do not count on equity!
MEASURING FINANCIAL RISK / SECURITY
No Debt Or Net Cash Position: You’re living as financially risk-free as possible. If you can cover your basic living expenses, you will likely never face financial calamity. Depending on your assets, it’s important to have health, auto, property, and excess liability insurance. Having no debt or having cash that exceeds your debt is an excellent position to be in by the time you are retired or no longer earning active income. No debt is better than a net cash position.
100% Debt / Cash: Every dollar of debt is matched by a dollar of savings e.g. $100,000 mortgage and $100,000 in a money market account. You will also likely never experience financial distress because you will probably never have to fire sale an asset due to a liquidity crunch. A 100% Debt / Equity ratio is risk-neutral. Shore up your financial security by developing as many income streams as possible.
200% – 500% Debt / Cash: An example is a $500,000 mortgage + $50,000 in student loans and $150,000 in cash. Such levels should be supported by secure income that has a high probability of growing over time. You should also have a plan to continue working for at least 10 years. The higher the debt level, the longer you should plan to work and the more income streams you should have.
600% – 1,000% Debt / Cash: You may have just purchased a home and exhausted all your funds e.g. a $140,000 downpayment has left you with just $50,000 in the bank and a $500,000 mortgage (1,000% D / C). This is generally a short term situation as you rapidly rebuild your cash hoard, and more slowly grow your income. You might want to pick up a side gig like driving for Uber. Be good to your parents! It’s important to do everything possible to grow your balance sheet.
1,000%+ Debt / Cash: With more than 10 times more debt than cash, you are at real risk of financial insolvency if anything should happen to your income. Your income must either be extremely high (new medical doctor making $200,000+ with lots of student loans who decides to buy a house), or something is wrong with the management of your finances e.g. took out a HELOC to spend on depreciating assets, massive credit card debt, etc.
Your number one financial goal is to pay down debt as quickly as possible while guarding against running out of cash should something unfortunate happen. Spending must go on lock down mode. Find ways to sell things you don’t use. You might even want to start a website to keep your debt payoff motivation high. There are hundreds of debt bloggers out there who’ve achieved fantastic results thanks to their community’s encourage.
VARIABLES TO REDUCE INSOLVENCY RISK
My debt-to-cash ratio is about 320%. In other words, I’m nowhere near a safe level for someone who no longer has a job. Entrepreneurship is risky business and Google could banish Financial Samurai and my other websites from their search rankings tomorrow!
A high debt-to-cash ratio is why I’ve been hustling to earn more money through corporate consulting clients so I can pay off one of a rental property mortgage early. With the volatility in the stock market, I’m even more motivated to raise cash in order to have buying ammunition.
My plan is to bring my Debt /Cash ratio down to 200% in 10 years, and down to 100% in 20 years before the age of 60. With the purchase of my fourth property in 2014, at 38, I’m no longer in the hyper asset accumulation phase unless I can win an attractive low ball deal. Making money selling a product online is more enjoyable than managing property at this stage of my life.
I would feel very comfortable having one dollar in savings match one dollar in debt. Even in true retirement, when due to arthritis, my fingers can no longer type. So long as I can make a combined $200,000 – $250,000 AGI a year through business income and passive income, having a ~$1,000,000 primary mortgage balance is ideal at today’s interest rates. A 2.625% interest rate is a relatively low hurdle for my investments to overcome, and the $200K – 250K / $1M mortgage ratio is the perfect combo for maximum taxation benefits.
Besides the level of income that may help lessen the risk of a high Debt / Cash ratio, the absolute level of cash is also an important variable as well. You may have $2 million in debt that costs $53,000 a year in interest to service, but if you have $1 million in cash, you’ll be solvent for the next 20 months, assuming no other income is received.
THE IDEAL MAX DEBT / CASH RATIO BY AGE
There’s no one size fits all Debt / Cash ratio because everybody’s risk tolerance and income generating abilities are different. But if I am to think logically about the necessities of debt to gain a college education and buy a home, here are the recommended Debt / Cash ratios by age.
The idea behind these ratios is to provide guidance for a typical person who goes through a typical arc of accumulating debt in the first half of his/her career and paying down debt in the second half of his/her career, with the goal of being debt free by retirement. Cash should not include stocks, bonds, real estate, or any investments that do not guarantee 100% principal.
During boom times, you want to be leveraged with as much debt as you can comfortably handle invested in appreciating assets. During downturns, the reverse is true. The goal is to not have to ever sell anything during a downturn due to a liquidity crunch. Many people who held onto their stocks and real estate between 2008-2011 are doing just fine now. It’s those who had to liquidate out of fear, a margin call, or a job loss who ultimately got hurt.
Before we die, it would be nice to have zero debt. This way, there’s one less organization to deal with when dispersing our wealth to family members and organizations we care about. But if you can’t get to zero debt before death, then try your best to get to a 100% debt-to-cash ratio by retirement.
Recommendation To Grow Your Wealth
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Updated for 2017 and beyond.