I’m pleased to bring you a guest post by faithful reader and commenter, Larry Ludwig (bio below). He writes a thought provoking piece about challenging the norm of becoming debt free. You’ll be smarter after reading this, guaranteed! Enjoy, and as always, feel free to debate away! Rgds, Financial Samurai
You’ve heard the financial gurus like Dave Ramsey perform pasectomies on his show and Suze Orman with her numerous “I have 50k in debt” guests. The gurus all say, debt is bad, credit is evil, and being debt free is nirvana, yada yada yada. While I do think as a whole Americans have too much consumer debt, the goal of being completely debt free is actually a terrible idea. Let me be specific: buying things that depreciate with debt is bad, that big screen TV, new clothing or car. Most of the financial gurus do not make this distinction and make all debt to be “evil”.
I believe Rich Dad/Poor Dad Robert Kiyosaki has said it best, “There is good and bad debt and being debt free is more risky than having good debt.”. Now before you go off on my recommendation of Robert and his questionable background, I believe his statement is sound and correct.
The primary reasons are:
• Opportunity Cost
• Asset Allocation
• Inflation
• Tax Deductions
• Arbitrage
• Leverage
Why Being Debt Free Is Not A Good Idea
OPPORTUNITY COST
In my case my wife and I just refinanced our house with a 30-year fixed rate at 4.875%. A great rate and will be probably not see rates lower in our lifetime. While we could pay off or accelerate the payments it does not make sense to do so. Why? Our actual mortgage rate after taxes is 3.26%, a very easy rate to beat with investments (especially pre tax) and in addition the average rate of inflation is also 3.26%.
With both taxes and inflation are expected to be higher in the future and it’s possible the actual mortgage rate will be even lower. It’s better to take the freed money that would have been tied into the house, and invest in other assets. In today’s environment you still can beat the above-mentioned rate.
Another way to look at, with inflation we will primarily paying only principal in real dollars with very little in interest payments. Your primary residence should not be looked at as an investment and if the numbers make sense take mortgage pre-payment dollars into other assets.
ASSET ALLOCATION
Let’s assume you take the financial guru’s advice and either pay off your home mortgage or accelerate payments. You will then have the proverbial “too many eggs in one basket” being your house. Most families that take this advice then cannot afford to build up an emergency savings or put money in pre-tax or after tax investments.
You’ll have too much of your dollars tied into one asset. Should pricing go down like we have seen in the past 2 years than you’ve lost real money. If you lost your job it would be much harder to get the equity out of your house to use in an emergency.
Pre-payment of your home mortgage should always occur last after any pre-tax deductions (IRA, 401k), or emergency savings. Even then, depending upon your real mortgage rate, it may not make sense to ever pre-pay.
INFLATION
Inflation has been called the “silent tax” and lurks at night eating away at your money. With our fiat currency and monetary policies, inflation is something our government wants to ensure always happens and at all cost. Being debt free robs you of borrowing money.
You not only want a ROI (return on investment) but a return OF your investment in real dollars. An example of this is a bank CD generating 4% a year interest, yet inflation is at 5%! While it’s great you have a safe investment, you are loosing %1 of your real money buying power.
Now you say what does savings have to do with borrowing? Everything. In general our government’s monetary policy is punishing savers, while helping debtors every way it can. This has become painfully obvious in the past year. You see this in every news headline and policy our previous and current administration has done.
Inflation is especially obvious with people on fix incomes (i.e. retirees). By having low fixed rate loans you are paying with future dollars that are worth less than currently.
What Will Happen With Inflation In The Future?
The $64k question is what will happen 10 – 20 years in the future? Will we have a Japan style deflation? Will stagflation of the late 70’s come back again? Will hyperinflation like Zimbabwe occur? There are a number of factors to consider:
• China and Japan will keep buying our debt? Will they just stop or slowly decrease their purchases since a devaluation of our dollar will hurt their exporting. The latter situation is more than likely
• Foreign countries that are buying our debt are now only buying short term debt. (less than 10 years). When this debt comes due, this could have massive issues for us.
• How with our government pay off the existing debt? Based upon interest alone we getting close to 40% of our yearly tax revenue.
• Will our government stop spending like drunken sailors with debt expected to pass 100% GDP in 2011? Unlike Japan, we do not have a country of savers to fall back upon.
• Will our government stop creating policies that will hurt small business?
• We are base currency for other countries, but for how long? If dollars start coming back to the U.S.A what would that do to the value of our currency?
• For the time being forget about the new health care bill, how will our government be able to fund the existing programs Social (In)Security, Medicare and Medicaid?
While there is no assurance of what the future holds, the question is do you want to ignore the risks, or hedge your bets? I choose the later with some assumption inflation will be higher than what we’ve seen for the past 30 years. Even so since 1914 the average inflation rate has been 3.26% and since 1971 (the year we completely came off the gold standard) it has averaged 4.48%, so always keep these numbers in the back of your head when debt taking on debt AND investing. By taking on low fixed rate debt, this is one simple method to hedge against inflation.
TAX DEDUCTIONS
If you are debt free, you lose your tax deductions.The Government wants you to be in debt. That’s right, why else would they have tax incentives like “Cash for Clunkers”, first time home purchase, and for businesses deductions on equipment purchases? The only logical reason is they want you to take on debt. This is related to the government’s monetary policy mentioned previously.
So if you are in the higher income brackets it makes more sense to use the tax deductions to your advantage. This is especially true on assets that generate income or increase in value over time. It’s also important to note, don’t take on debt just for the tax deduction alone.
ARBITRAGE
Arbitrage is just a fancy term making a profit from the difference in market prices. I just received a credit card offer for 0% interest for one year, with check writing expenses it was 2.99% fixed for one year, much lower than any other of the current credit card rates we have.
In the next year it’s expected all credit card transactions are going to go up dramatically. With that said if I take a one-year low interest loan and make 6% in a safe investment I’ll come out ahead with a 3% difference. This example assumes inflation and taxes paid are 0%, not completely realistic but you get the idea. While there is some risk involved (as with any investment) the risk is somewhat low and will take my chances on this type of arbitrage.
Let me also add another form of arbitrage we saw in the previous years with one of our credit cards. We had a 4.99% “fixed” rate credit card that also offered great card rewards. I recently calculated any interest we paid, minus all of the gift cards we received.
It turns out the credit card company paid us over $600.00 in the 3 years we used it and this is after any interest payments incurred! So our interest real rate on this credit card was negative. Not a bad deal if you ask me.
LEVERAGE
If you are debt free, then you won’t be able to leverage cheap money to make even more money. Leverage is one of the reasons why real estate is such an attractive asset class.
I’ve seen articles that state rental housing is a poor investment compared to stocks or bonds. They use the typical statement of housing matches inflation or slightly less. While this is true, it does not take into account the use of leverage.
Lets use an example of putting down 20% on a $100,000.00 rental house. We’ll assume over time the house increases in line with inflation, and use 3% a year. So in the first year it increased from $100k to $103k, assuming the property is cash flow positive, the property increased in value 3k without doing anything. With your $20k investment, just increased to $23k or a 13% increase. So with leverage you made more money with the assistance of inflation.
Using leverage while does increases risk, it can be used to your advantage. Too much leverage (like many of the failed banks) can destroy you. So the question becomes how much leverage do you take on?
For housing the typical 20% down payment makes sense and should be the bare minimum. For other assets it really depends upon your risk tolerance, asset allocation and long-term goals.
The housing market will likely stay hot for a long time thanks to cheap money and leverage. And if you the U.S. housing market ever gets as hot as the Canadian housing market, watch out! Expect to see another 30%+ increase in prices.
Debt Free Is Not Optimal
I’m not saying go out to Macy’s and Best Buy max out your credit cards on deprecating assets. I am saying use debt to your advantage. Leverage assets that in the long run increase in value and/or generate passive income, while using cash to purchase deprecating assets.
Don’t assume that all debt is “evil”. When using debt and risk management properly, it is one of secrets of becoming wealthy. If used improperly can enslave you for the rest of your life.
Related: FS DAIR: A Framework To Pay Down Debt And Invest
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Just wow! So you all want to be in debt when you retire? All you’re doing is playing with fire. We are not going to win the ‘debt game’, it’s all sharks out there. Having the money I used to pay on my mortgage is making me prosper. NOT giving anyone else my money every month has given me so much freedom I want to shout from the rooftops. All the other stuff is just jibber jabber. This is not rocket science.
That doesn’t make much sense. Debt free doest’t mean investment free.
There’s no such feeling as being debt free and not have to worry about any repayments including mortgage.
Hi Rockin, have a read of this post. It helped build $450,000 in wealth in just 9 years, and it was relatively painless and stable.
https://www.financialsamurai.com/2012/10/16/real-estate-is-my-favorite-investment-asset-class/
Back to debt, the article author wrote “Using leverage while does increase risk, it can be used to your advantage”.
This notion that debt increase returns but also risk is illogical- risk of permanent capital loss *erodes* returns. Yes, an investor may enjoy 20% returns due to debt leverage, but if it leads to –40% or more in one year, then the net worth is crushed.
And the temptation to ramp up the debt once started is too great, so don’t start.
Just save the income and teach yourself how to maximise returns whilst keeping the risk of a loss greater than 10% in any year on your investments to a tiny probability… and you’ll be 100% guaranteed to reach your goal.
Why leverage your assets (beyond education debt, own mortgage, start-up or investment property) in an attempt to reach your goal say 5 years earlier, but with a small chance of utterly failing?
Investor Junkie-
You say “starting the first year of a bull market… it’s possible”. FTSE All share index (he’s a UK investor) rose just 40% between 2003-2010 = 7% p.a. minus 30% p.a.= 23 percentage point difference. This is very doable when managing under $1m for a rational value investor. Buffett did 22% point difference to the Dow in the 1960s and Munger did 19% point difference in the same period and incredibly with far, far more money than <$1m in 2010.
You say “he will regress to typical averages”.
I agree that, in c.15 yrs from now, his $10m will have lower average annual returns of around 20% p.a. instead (and 15% p.a. on $100m will be excellent).
You say “I suspect real returns after expenses… it’s much less”.
These returns are after expenses: the portfolio has a 65% turnover rate, so each stock is held for 1.5 years on average and this is for a 7 stock fund only. So the trading cost is around 0.3% of the portfolio net asset value p.a.
The capital is pension money, so it’s pre tax. At 20% capital gains tax, the returns would conservatively be 25% p.a. average.
You say “if he’s done it more via buy and hold… his return wouldn’t jive with what professional[s]… saw in 2008”
Yes, the style is entirely value investing and his returns do not jive with the pros dire results in 2008 because a. he held up to 40% cash in 2007 (due to being unable to find cheap stocks), whereas the pros often have to remain fully invested and b. he did not suffer clients making panic redemption calls on the fund that would lead to forced selling of stocks at the lowest prices.
@Karl
Ok approx 7 years of returns you are stating. A sub 10 year, especially starting the first year of a bull market is most definitely possible to achieve 30% in that short of a time frame. My point is, if your friend or you think he’ll continue this trend for year 10, 15, or 20 in the future. The trend is not a realistic, he’ll be assimilated closer to more typical averages. Especially with some of the possible headwinds and unknowns coming down the pipe. I would congratulate your friends returns, if in fact they are real. Like I stated before if he’s able to pull this off in the long term, he’ll be on course to be one of the greatest investors of all time!
If you haven’t proof (ie a statement) it becomes more of “the big fish I caught” story. I assume this is an active trading strategy in order to achieve the returns he got. I suspect real returns after expenses (let’s for now not even discuss taxes) it’s much less than the 30% mentioned. If he’s done it more via buy and hold and value investing methodology, his return wouldn’t jive with what professional value investor returns we saw in 2008 (to use a known benchmark). Value investors saw some of the worst returns during that period.
To circle back to why I commented on your original reply. Your friends investment returns is an outlier and not typical returns MOST people achieve, even the “professionals” who aren’t chained by certain rules (ie mutual fund managers and the amount they can invest per company) To say an investor shouldn’t use debt to help amp returns, if the debt pricing and ratio isn’t right is just plain silly. Debt, just like investing, has risks. Both should be used appropriately and wisely.
If your expand statements and it were applied to all businesses and investing some very interesting results would occur. Not using debt in business or investing would lead to more stable but below our historical normal returns. Just what I believe we’ll see in the next 10 years of below optimal returns on the flip side. Too much debt to pay down also leads the same path. My point it should be balanced. To attribute to FS theme there, a yin and yang of debt and investing. Cheers!
.-= Investor Junkie´s last blog ..How Much is 1% Costing You? =-.
Beyond debt for an education and own home mortgage, I would only use a max. of 50% debt to 50% own capital if starting a company with *limited liability* protection (and pay off the debt a.s.a.p) or as a shrewd real estate investor (most only think they’re shrewd). This fits with Kiyosaki’s view. Otherwise, avoid debt like the plague.
Certainly, playing with “credit card 0% interest” and credit rating games is not financial intelligence but instead is an attempt by consumers to game a system that is ultimately gaming the consumer- a farcical situation.
It would be great if the article’s author wrote about finance as the real experts- businesses- handle it. In other words, could managing your personal finance based on how businesses have taught it to the consumer ever lead to wealth?
(continuation from post above…)
Note- the more volatile the asset, the greater the return so it’s tempting to borrow at 5% and invest at 30% p.a. average return. But a cash call from a lender at a weak point in the volatility could permanently cripple you. Alternatively, borrow at 5% and invest at 8%… but there is still asset volatility simply due to earning that extra 3% spread, so you’re still vulnerable to collapse but this time earning less returns.
This risk of bankruptcy may only be 1% a year, but add that over 20 years= 20% probability. Too risky.
Beyond debt for an education and own home mortgage, I would only use a max. of 50% debt to 50% own capital if starting a company with *limited liability* protection (and pay off the debt a.s.a.p) or as a shrewd real estate investor (most only think they’re shrewd). This fits with Kiyosaki’s view. Otherwise, avoid debt like the plague.
Certainly, playing with “credit card 0% interest” and credit ratings is not financial intelligence but instead is an attempt by consumers to game a system that is ultimately gaming the consumer- a farcical situation.
It would be great if the article’s author wrote about finance as the real experts- businesses- handle it. Could managing your personal finance based on how businesses have taught it to the consumer ever lead to wealth?
@Investor Junkie
(continuing from the the above post)…
Note- the more volatile the asset, the greater the return so it’s tempting to borrow at 5% and invest at 30% p.a. average return. But a cash call from a lender at a weak point in the volatility could permanently cripple you. Alternatively, borrow at 5% and invest at 8%… but there is still asset volatility simply due to earning that extra 3% spread, so you’re still vulnerable to collapse but this time earning less returns.
This risk of bankruptcy may only be 1% a year, but add that over 20 years= 20% probability. Too risky.
Beyond debt for an education and own home mortgage, I would only use a max. of 50% debt to 50% own capital if starting a company with *limited liability* protection (and pay off the debt a.s.a.p) or as a shrewd real estate investor (most only think they’re shrewd). This fits with Kiyosaki’s view. Otherwise, avoid debt like the plague.
Certainly, playing with “credit card 0% interest” and credit ratings is not financial intelligence but instead is an attempt by consumers to game a system that is ultimately gaming the consumer- a farcical situation.
It would be great if the article’s author wrote about finance as the real experts- businesses- handle it. Could managing your personal finance based on how businesses have taught it to the consumer ever lead to wealth?
@Investor Junkie
Re. 30% p.a. returns, to be clear this is average return. Some years were less (1% in 2008) and other years were more (56% in 2009, 48% in 2004). So it’s 30% p.a. average return since 2003.
He achieves this by:
1. investing in small to mid cap equities
2. only in industries he understands (excludes 4/6ths of the stock market).
3. managing $500k and that relatively small amount of capital is his structural advantage over investment institutions, as he can invest in small companies off the radar of the professionals
4. runs a focussed 7 stock portfolio- he splits the capital into 1/7th portions and invest one chunk when a dirt cheap company appears, and that only happens a few times a year, so the 30% returns are best achieved via part-time investing (months of no trading and the occasional 12hr research into one company)
5. he avoids debt like the plague- both portfolio leverage and individual company debt- because we know that a capital loss through borrowing can ruin the compounding process.
6. he works hard at being rational; he understands that a little side bet on the golf course can lead to more gambling in his life and exactly the same happens with a ‘harmless’ bit of debt to juice returns leading to more and more debt.
7. finally, occasionally a holding of his might fall by 50% shortly after purchase and so he buys more, but leverage would not allow him to stomach such short-term volatility.
If that capital was $10m, the average returns would drag down to say 20-25% p.a. average. I agree with you that Buffett’s returns are phenomenal on $100bn+.
Google “50% per year Buffett return”- Buffett says it’s possible to achieve 50% p.a. average return with sub $1m, but that’s a full time job and you have to be really fanatical about the process.
So these returns follow a power law distribution curve, with average returns on the y axis and capital sum being invested on the x axis. The more capital, the lower the average returns.
Sorry, maths mistake. The risk of bankruptcy may only be say 1% a year, but over 20 years = (1-0.99 to the power of 20) = 18.2% probability of bankruptcy at least once in 20 years (not 20% chance as mentioned before). Still, too risky.
@Karl:
Over leverage yes is VERY bad. How much is over leverage? Depends upon a few factors. Debt can amp your returns, but it can also destroy you. exhibit A: banks from 2 years ago. The author never states over leveraging. A good portion of debt is personal debt is consumer debt, not in investments. You are 100% people should not purchase assets that always decrease in value with debt.
I call BS on your 30% return guy. For how many years consistently??? Investing in what? If this “guy” you state gets that amount every year he has to be one of the best investors to ever live! Better than Buffet, who has averaged 23% (if memory serves me correct) Is it possible to get 30% in one year (don’t forget last year the S&P was 22% up YOY) but consistently… ah no.
.-= Investor Junkie´s last blog ..How Much is 1% Costing You? =-.