In a Perfect World, No Debt! But Our World Isn't Perfect

Debt is risky, and, in a perfect world, we would all rather avoid risk. The problem is that we do not live in a perfect world.

In their Nobel Prize–winning economic theorem, Franco Modigliani and Merton Miller hypothesize that capital structure (how much debt a company has) doesn't matter in a perfect world, but we don't live in one.¹ In our imperfect world, how much debt companies carry matters quite a bit. Companies carry debt because it works for their bottom line even though they likely have the resources or could raise money to pay for things in cash.

People, on the other hand, do not have this luxury. Our ability to buy things is limited to our income, assets, and use of debt. No one would need debt if we could rent everything we want and need, under terms and conditions we find desirable, and at a cost equal to what it would cost to borrow money to buy. In this perfect world, most people would be neutral to renting versus buying—and renting would often make more sense.² You don't buy a car and house for a one-week vacation in Hawaii. You rent because the terms and conditions are much better than buying. This same concept could apply to everything in your life, but it doesn't for a combination of financial and emotional reasons.

In our imperfect world, many people use debt to buy things they could not otherwise afford with cash they have on hand, including houses, cars, education, or investing in their small business.³ As a result, many—if not most—people choose to take on debt early in life and spend their lives trying to pay it down. Is this a good strategy? Should people borrow money? If so, how much should they borrow? How fast should it be paid down? How does buying compare to the alternatives?

You Owe a Debt to Your Future Self

Whether or not debt is bad or debt is good depends on your resources relative to your needs. If you can afford to pay cash for something, then paying cash might be a great idea. But whether or not you can afford it is just one part of a much bigger picture: If you want to retire, you owe a debt to your future self.

If you are 100 percent confident that retirement isn't an issue for you, then you have a lot of flexibility and could consider the potential benefits of paying cash for everything. However, most of us have to work and save in order to retire. I, for one, do not have enough money to retire tomorrow with the lifestyle I would like to live. For those of us in this situation, we have a dual mandate—we need to reduce our debt and save for retirement.

If you are like me, you want to enjoy the journey along the way, too. I want to see the world and live in a house big enough to host parties. I'm happiest by a campfire and I don't need anything extravagant, but I like doing some crazy things from time to time. If we want to also enjoy life, it's actually a tri-mandate!

Around most kitchen tables, a conversation begins whenever extra money comes in (perhaps a bonus or a raise). Should we pay down debt? Should we buy that thing we've had our eye on? Should we save toward retirement? Should that savings be in our retirement plan or in our investment account? And if we invest it, what should it be invested in? Maybe we should get that new house after all.

I've studied finance my entire life. There are about a million articles telling me how to invest my money, predicting the future (and generally being wrong), and feeding me financial news 24/7. Why do I feel like we are always guessing on these important decisions? What about my debt? How much should I have, and how should it be structured? Why does everybody tell me to get rid of it? I only have so much money; if debt is bad how do I handle my tri-mandate of saving, enjoying life, and paying down debt?

So how can I be responsible, have the things I want, enjoy life, yet save toward the future, be on track to retire, reduce anxiety, and increase flexibility? I value flexibility and hate being trapped; I want freedom. Will being debt free give me freedom? Or is there another way?

Break the Paycheck-to-Paycheck Cycle

Money flows into every household like water through a hose. When all is well, it flows freely and abundantly. But a kink in the hose (loss of a job, a serious medical condition, even a natural disaster) could stop the flow. If you haven't been storing water in cisterns, you and your family will be parched and in peril.

Too many Americans are in exactly that position. According to one survey, 76 percent of Americans live paycheck to paycheck, fewer than one in four has enough money saved to cover at least six months of expenses, and 27 percent have no savings at all.⁶ A separate survey found that 46 percent of Americans have less than $800 in savings.⁷ The estimated collective savings gap for working households 25–64 is estimated to be between $6.8 trillion and $14 trillion. Two-thirds of working households age 55 to 64 have not saved more than one year's worth of salary.⁸ The well is not deep enough to sustain them through a crisis.

Is it possible the conventional wisdom that debt is bad has contributed to our savings gap? I believe our anti-debt mentality is contributing to the fact that we are dramatically under saved and ill prepared for crisis. I believe it's time to consider a new glide path and to break this cycle.

I believe there is a better, balanced, and simple way to accumulate wealth by using both sides of your balance sheet—your assets and your debts.

Companies Embrace Balance

Every successful company in the world has a chief financial officer (CFO) who looks holistically at the company's finances to maximize resources and profits. You and your family are not a company, and I understand that there are important differences. But a CFO's raison d'être is to do well financially, and we can learn some important, broad lessons from CFOs as we establish our personal, financial glide path. I believe one of the important tips we can take from CFOs is how they work both sides of the balance sheet to design and implement an overall debt philosophy and establish lines of credit as part of a holistic picture.

Structuring the right amount of debt in the right way is 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.⁹ Every corporation in the world uses debt as a tool to fund operations and leverage opportunities, and you and your family should, too.

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).

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.

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:

1. They both start at 35 years old.
2. They start with zero assets.
3. They both make $120,000 per year and never make a penny more or a penny less.
4. If they invest money they earn a rate of return of 6 percent.
5. If they borrow money they can borrow at 3 percent.
6. Their house appreciates by a rate of 2 percent per year.
7. They both save $15,000 per year ($1,250 per month).
8. 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 and still have $200,000 more than the Steadys and $450,000 more than the Nadas!

But these are the Radicals, so what if they left their $1.75 million invested and kept the mortgage forever? At the same 6-percent return, they would have a monthly income of $8,750. They would still have to make the $750 interest payment on their mortgage leaving them with $8,000 per month in income. This is more than the $7,500 they were spending when they were working. The Radicals' monthly income increases during retirement.

What about inheritance?

If the Nadas don't change their spending habits, they are on track to run out of money in 18 years.

If the Steadys don't change their spending habits, they are on track to run out of money in about 30 years.

If the Radicals don't change their spending habits, they are on track to have about $2.5 million when they are 105 years old.

And the Radicals' kids? Sure, they'll inherit debt—$300,000 worth of it—but they are inheriting far more in assets and are easily able to repay that debt and still have more money than the Nadas or the Steadys. Would you rather inherit $2 million of assets and $300,000 of debt, for a net of $1.7 million, or $500,000 with no debt?

The math proves the “Debt is Bad” belief is false and that “Debt Adds Value” is true. This short story summarizes The Value of Debt and The Value of Debt in Retirement, my earlier works.

The problem is, simply saying “Debt adds value” is generally unsatisfactory for many reasons:

• The assumptions are too broad and unrealistic; it doesn't represent the real world. This leads to more questions than answers and a lot of debate.
• It is unlikely to be right; the actual results will be dramatically different.
• It isn't dynamic. It doesn't reflect the changes we experience throughout life.
• It isn't specific or actionable. It doesn't provide a glide path or insight into the appropriate amount of debt to carry throughout life.

Because of the dynamic nature of our lives and the world in which we live, we need something more.

Finding Your Glide Path

In our current world order, most people have high levels of debt early in life and race to be debt free by the time they retire. Along the way, they experience stress, anxiety, and financial insecurity. Is there a better way? To find out, I set out to design a more fluid, dynamic formula using the following building blocks:

1. Core Tenets
   1. People's preferences: In a perfect world, we could rent everything we want and need with the terms, conditions, and price we desire. However, we do not live in a perfect world.

      For financial reasons or personal preferences, most consumers choose to use debt at some point in their lives. Most choose debt reluctantly. They do not like debt and want to be debt free.

      Most consumers want to retire.

   2. People's reality: Most consumers are not on track for retirement and/or have anxiety about having enough money for retirement.
      • Many people feel stress and anxiety about money in general.
      • Many live paycheck to paycheck.
      • Money is one of the leading causes of fights in relationships.
      • Most do not have the freedom and flexibility they would like.
   3. Companies: The vast majority of companies choose to embrace debt. There are far more AA-rated than AAA-rated companies, and more A-rated than AA-rated companies.¹² A lower rating is a proactive choice, a strategy to embrace debt.
   4. Math: Compounding interest is powerful. The longer money is working for you, the bigger difference it makes.
   5. Finance: In their Nobel Prize–winning theory, Modigliani and Miller said that in a perfect world, debt does not matter.¹³ Because we do not live in a perfect world, capital structure (how much debt companies have) matters.

      In his Nobel Prize–winning theory, Harry Markowitz said that one of the biggest determining factors in your rate of return is your capital structure—how much debt you have.¹⁴

   6. Strategic debt philosophy: There are different types of debt. Some are bad, and some can be good.

      If you are ahead of your goals, you don't need debt. If you are behind on your goals, debt can be a powerful tool. This is because:

      • It is a mathematical fact that debt can reduce risk.
      • It is a mathematical fact that debt can reduce taxes.
      • It is a mathematical fact that debt can increase return.¹⁵

The Need for Specific, Actionable Advice

One day I was walking through the airport and somebody stopped me and said: “Hey! You're the guy who wrote that book about debt! How much debt should I have?” When I share this story, people chuckle. It's a great question, but how could I provide him with specific information, on the spot, that would be relevant to his life? He was not looking for me to pull out my fancy calculator and give him an answer to how much value debt could create. He was looking for an actionable plan and a path.

When I do media interviews, reporters show little interest in what people who already have money should do. The vast majority of us are still trying to make our money in the first place. There is tremendous demand for ideas about what people who are accumulating money should do at each phase of their life. People want to understand the potential benefits and risks of taking on debt—oh, and please make it very simple and easy to understand!

In my other books, I've said that debt ratios between 15 percent and 35 percent may be optimal over the long term.¹⁶ In these works, I illustrate that this range is more conservative than most companies use, and that debt ratios of 33 percent may reduce risk, lower your taxes, and increase your returns. However, these ranges are based on individuals who have already accumulated considerable assets. They do not accommodate early accumulators.

For example, using the debt ratios in my previous works, if you wanted to buy a $500,000 house with a $400,000 mortgage, you would have to accumulate about $700,000 in assets first. Similarly, if you want to purchase a $250,000 house with a $200,000 mortgage, you would need to first acquire $350,000 in assets.

While this is possible, it is extremely unlikely for most people. The reality is most people will take on a higher level of debt early in life to buy the house. Then they are faced with juggling how to pay down debt, save for retirement, and enjoy life. Many young accumulators also have other debt, like student loans, credit card debt, car loans, or all of the above. They need to add this to the equation and figure out how and when to pay down their different types of debt. We need a balanced approach that is flexible so it can evolve with us throughout our lives.

It is my belief that in our anti-debt world, most people are taking on too much debt too early in life and paying down that debt too aggressively. As a result, they are not saving until later in life. I believe this strategy is a considerable cost to society and that there is a better, more balanced path.

What follows is a new glide path, what I consider a balanced approach that looks at the four phases of L.I.F.E.:

1. Launch. When your net worth is low and/or you are truly just getting started
2. Independence. When you have accumulated a small nest egg
3. Freedom. When you have a medium nest egg
4. Equilibrium: When you have a large nest egg, are living a balanced life, and are preparing to retire

We'll examine these phases as interconnected, a baton passing from one hand to the next in the relay of life. As the size of your nest egg changes, the debt ratios change. However, each has similar balance. Similarly, each phase of your financial life involves a different base amount and objectives but builds off the same inspiration. We'll consider both sides of the balance sheet. We'll look at tools to address the variances and differences in our lives. We'll keep the ideas big picture and approachable and let you turn to the guides, appendices, and online resources for more in-depth details. The goal is not to force a fit, but to consider new parameters, new buoy lights to inspire you to find YOUR glide path.¹⁷