CHAPTER 8
The Debt Trap
Freeing yourself from dependence on debt.
Isn’t it funny how the socially accepted ladder in life involves accumulating more and more debt, and more and more recurring expenses? Get your first job — get a car loan! Get a higher education — get a student loan! Start your career. Get a first home — get a home loan! To make sure you can pay back all those loans, you had better get some income protection insurance, and car insurance, and home insurance, and finally death insurance for when you work yourself into an early grave! And on top of all those recurring expenses you had better start making some regular payments towards your retirement too. One thing after another, binding you tighter and tighter to your job, forcing you to work for a salary for the rest of your life. In chapter 7 we talked about how being dependent can limit your thinking and creativity. Nowhere is this truer than with our reliance on debt, and our dependence on passive growth. And not just individually: virtually the whole world — nearly every country — is addicted to debt too. Despite the familiarity of this life path and the centrality of debt to it, the past 100 years are actually quite historically abnormal. Over this time, the money supply has been consciously expanded, and since the 1980s the use of debt in particular has exploded, fuelling bubble after bubble and driving up the costs of some of the most critical things we need — giving rise to what is known as the FIRE (finance, insurance and real-estate) dominated economy, which has seen stagnant wages on top of ridiculously high house prices. Except during war times, inflation in the past was essentially zero on average. One dollar in 1800 would buy you approximately the same amount of stuff 100 years later. From 1913 to 2018, however, the value of the dollar declined 96 per cent; what you could buy for $100 in 1913 would cost you $2529 in 2018. In the past, periods of inflation would be followed by periods of deflation pretty regularly. While there have been periods of deflation over the past century — where the value of the average person’s savings rose while the assets of the wealthy fell — these were few and far between and have been bitterly fought by central banks every step of the way. Which is curious, because deflation literally decreases income inequality. In the past, the economy expanded and contracted, it grew and it had seasons. Then we decided to try to abolish those seasons and institute constant growth and constant inflation. The bargain always was that while people’s wages and savings would buy less and less each year because of a deliberate policy of inflation, their salaries would rise even more to compensate for it. But despite this implicit promise, everything that could be done to keep wages low has been done instead. Wages haven’t inflated — assets have. I wonder who that benefits more, the rich or the poor? Some economists have argued that rising asset prices make people feel wealthier — so they spend more — but as others have noted it’s rising incomes, not rising assets, that encourage people to spend in any sustainable manner. And in real terms (adjusted for inflation), wage growth has stalled for decades. Incomes have barely changed in 40 years, which is bad enough for people who are working — but what about those who’ve stopped working and have retired? When you stop working you still suffer the fall in purchasing power of your savings, but you no longer earn a rising income (if your income was rising at all) to offset it (assuming you’re living on a fixed income). So after a lifetime of work, retirees can’t just live out their days on the money they’ve saved: they have to invest their money just to keep up with the artificially declining dollar that we’ve mandated in our attempt to eliminate economic seasons. A market can never be free, if debt bids the prices we see. Financialisation, has harmed every nation, it’s why we’re now hooked on QE. Unknown In the lead-up to the financial crisis in the United States there was a small group of investors including Dr Michael Burry who, like me, saw what was coming, and by going against nearly everyone else at the time were able to make $1 billion profit when the market collapsed. There was a good movie made about them called The Big Short. It turns out what they were looking at was the rampant financialisation of debt in the United States. They could see that the loans against housing, which formed the basis of the new products Wall Street was creating and trading, were very unsound, but either nobody was paying attention or nobody cared. While those investors close to Wall Street were predicting the crash based on debt, in Australia I was predicting the problems with debt based on looking at demographics. No matter how cheap interest is when people reach retirement, they want to pay down debt. Debt only makes sense to most people when they are working and have the income to service it. The whole point of debt is to afford something that is too expensive right now, or to get leverage on your assets so you can grow them more quickly, and to build up enough equity to live off in retirement. But with an ageing population facing retirement, and a younger generation facing stagnant wages while having the lowest workforce participation rates in recent memory, it no longer makes sense for people to take on as much debt. But, just like in 2007, while plenty of people are aware of this situation, almost everyone is in denial, and private debt levels are still worryingly high. We are starting to realise that debt itself doesn’t magically create growth, and that piling on debt clearly isn’t working anymore for our economy. But what about for us as individuals, as wealth creators? For decades now the mantra has been ‘there’s good debt and there’s bad debt’. But during the GFC we were living through a time of deflation, which meant that the value of assets wanted to fall while the value of our money or savings wanted to rise. On top of this ‘natural’ deflation, we had governments that were doing their best to fight it by rapidly increasing their debt and balance sheets. The result was a kind of disinflation, or period of prolonged anaemic growth. Barring the correction in house prices that came with the GFC, on paper the Australian economy did okay — the aggregate GDP (Gross Domestic Product) continued to grow, a little. But that was achieved only through the highest rates of immigration of any Western nation. While GDP went up, GDP per person did not, and while property prices did rise again beyond their previous peaks, wages across the economy stagnated. Was my advice to Andrew to not take on the most debt possible — buying the most expensive house he could, in the hope that his rising salary at his job would cover it all — wrong? No. When the correction came, it was the upper end of the market that was hit first, and while the lower end of the market did okay, the upper end was also the slowest to recover. A decade later property prices in capital cities fell again. The era of endless growth was replaced by a period of increased volatility. By following my advice, Andrew avoided getting caught in the pullback at the upper end of the market, turned his home into a modest investment, and increased both his cashflow and his freedom, so he was not only still exposed to the rising housing market, but in a better position to stay invested in it too. Not only that, but by avoiding tying himself to a mega mortgage and clinging to his job to pay for it, he was free enough to embark on a totally new venture as well. So even though passive growth did continue to occur, it was much more selective, and leveraging yourself to the hilt to take advantage of passive growth in general, and counting on rising wages, was not the smart move. Clearly such simple advice as ‘take on good debt, to get leverage, to buy assets’ is no longer enough. Everything popular is wrong. Oscar Wilde In fact, most mainstream advice is usually outdated at the time. I remember in the 1990s, after the inflationary 1980s, financial planners were still extrapolating the double-digit returns of that period as if they would continue forever. I remember hearing one say ‘saving is for losers’! (Yes, someone actually said that! I’m sure they were only being half serious though, the implication being that if all you did was save money, and you never bought any assets, then the rampant inflation we were experiencing in the 1980s would see your savings fall in value while property was rising in value rapidly. So that may have been good advice — a decade earlier!) When property is rising by double digits, holding property for passive growth, taking on debt and negative gearing seem to make sense. During the 20th century, real estate prices generally went up. But not always, and this was historically unusual: something that was driven at first by post-war demographics and compounded by governments easing interest rates and lending criteria. At the end of the 1980s the bubble popped, and a recession set in that saw prices flatten into the early 1990s. Responding to this new, flat market, some began to advise not to hold assets for passive growth at all — hold them for passive income. By the time this advice became mainstream it was already becoming outdated, as prices again began skyrocketing and the passive growth party was back in full swing. However, there is a kernel of truth to this advice: ultimately assets aren’t meant to grow passively — they are meant to yield returns. If a business, for example, increases its earnings, only then should the company’s worth grow to reflect that. … with property in particular, we’ve come to expect that prices should always rise. But with artificially low interest rates, any asset that yields a decent income is quickly bid up in price by people desperate for a return, until the yield falls in line with the artificially low returns that have become the norm. And with property in particular, we’ve come to expect that prices should always rise. Lowering interest rates makes it easier to pay more for a property; but they don’t make the property itself any more productive as an asset. What worries people the most, though, is that we have been pushed into a world where all the old securities are being stripped away and more and more risk is being forced onto us. People are concerned, asking: Will my pension last? Will my retirement savings continue to grow? Will my house keep rising in value so I can maintain my standard of living, even as my expenses rise? You don’t want to work your whole life just so you can be independent enough to retire, only to find that although you may no longer be dependent on a boss, you are now dependent on a faceless market that’s beyond your control: it can’t be appealed to, you can’t ask it for a raise and it certainly doesn’t care about you, or how long you’ve worked to pay down your loans and save up your money just to invest in it. It’s time to take back control. The world has become financialised; as individuals there’s no changing that. But we can work within and around this new reality and recover from dependence on debt and addiction to assets. Each generation has had an overarching view on debt. The so-called ‘greatest generation’ (who grew up during the Great Depression) viewed debt as bad. Having lived through hard times, they knew that debt could eat you alive, so they avoided it. Savings, on the other hand, really helped. The baby boomers grew up with parents who valued saving, but coming of age during post-war prosperity, the baby boomers came to expect growth to continue — and as a result of their large numbers this was a self-fulfilling prophecy. At each stage of life, boomers created large consumer trends that drove prices up constantly. They came to see debt as something that, on one hand, could be bad if taken on for consumer products, or on the other hand, good if taken on for assets. The inflationary 1980s — when interest rates shot up sky high — are largely responsible for this. You could be seen to be sophisticated by simply taking on good debt. Taking on bad debt or just saving, by themselves, were seen as unsophisticated. The ‘smart’ people were taking on investment loans and negative gearing. The generations that followed the boomers have seen assets rise and fall. They’ve seen interest rates at all-time lows, so debt has been tempting to take on; but the returns for taking on that debt have been diminishing too. The cost of things has continued to rise, and so debt has become ‘necessary’ for a lot of things that once were cheaper. Education is the obvious example. Education has become increasingly expensive, and as more and more people get degrees, more and more people need to get degrees than ever before. At the same time the returns from higher education are diminishing: with wages stagnating there is even less certainty of a secure job at the end of it. (For millennials, not only has college debt increased, but their income relative to previous generations has also decreased.) On top of all this, the jobs we do get are rapidly changing so that not only are the degrees we get obsolete in no time, often the industries we work in can become obsolete too. To keep the party going, to ensure asset prices continue rising well beyond their intrinsic value, we’re enticing people into debt slavery and also doing everything we can to stop wages rising in value. We’re even doing away with the idea of full-time work itself. People need income to service debt, and we can only lower the interest on debt so far: can you see why it’s easy to predict that this state of affairs can’t continue? The lifelong consequences of student debt Recent studies have found that there is a negative correlation between student loan debt and the establishment of small businesses. What this means is that young graduates with a crushing student loan debt are encouraged to avoid the risk of starting a business and instead reach for the security of the ‘stable income’ that a job promises. Student debt can also affect credit ratings, making it harder to get a business loan. Our over-credentialised world with inflated education costs is causing fewer of our youth to start businesses — yet small businesses create the majority of new jobs. It’s a catch-22: debt makes people desperate for jobs, but in the process suppresses the entrepreneurialism that creates jobs. This is a terrible side effect of the student loan bubble all by itself — stunting our growth at just the age when most people are likely to be willing to take risks — but the consequences are longer lasting too. People are paying off student debts for more of their life now: the average length to pay off those loans has risen by 80 per cent. This is having a major impact on the ability of our youth to create ‘lifetime wealth’. Research has found that households without any student debt obligations have about seven times the typical net worth of households headed by a young, university-educated adult with student debt. Not only does this debt delay the ability of graduates to start building wealth, it also has a fundamental and profound effect on other markers of lifetime happiness and success, for example it can significantly decrease the long-term probability of marriage by a significant amount as well. If all that wasn’t bad enough, an article in The New York Times on this new ‘debt slavery’ described how students were being encouraged to sign away their rights to future income in exchange for investors’ help with their tuition. This is literally serfdom. Instead of lords and tenants, we have financial elites and students/employees. Instead of dealing with the runaway credentialism and the bloated administration that is fuelling the education bubble, we’re taking an inherently unstable ‘asset’ (higher education) that is maintaining its inflated ‘value’ only through more and more debt, and we’ve started bundling and packaging up all this ‘bad debt’ in a way that is eerily similar to the mistakes made in the subprime crisis. Our views on debt have changed over the generations: To ascertain the true costs of debt we need to ask ourselves: Having lived through several market crashes as an active full-time investor, I can tell you that maximising your leverage through debt is nuts. It’s way more important to survive the many seasons than it is to try to maximise your harvest in any one season. Our over-credentialised world with inflated education costs is causing fewer of our youth to start businesses — yet small businesses create the majority of new jobs. Always go into a deal with some equity so you can ride out any corrections. If you’ve got at least 20 per cent equity, in most cases you’ll be fine; less than that and debt can kill you. Even ‘good’ debt can be bad. After the GFC there were many stories of people who had maximised their ‘good debt’ to buy several investment properties, only to end up homeless, living in makeshift ‘tent cities’ in the United States. Besides that, even in the best-case scenario, cranking up your debt to the max ties you to your primary source of income — your job — at a time when jobs are less secure than before because income is needed to service debt. As you saw, part of having a new view on debt is being prepared to question what everyone else is doing, and resist the temptation to take on the same debts as everyone else. This can be as simple as not going into massive debt for a degree with no guarantee of a job at the end of it, or as sophisticated as the example I shared with Andrew, where taking on a manageable amount of investment debt made more sense at his stage in life than taking on the more massive debt he was contemplating for a home. Renting versus buying One piece of conventional wisdom almost nobody questions is whether it is better to rent or to buy a home. You’ve probably heard ‘Rent money is dead money,’ ‘If you rent you’re just paying the landlord’s mortgage’ or even ‘You can’t live in a share/stock.’ I don’t want to get bogged down in comparing renting and saving versus just buying a home and paying the mortgage, because ultimately, for most people buying a home is a stage-of-life issue, a security issue and a family issue, and not a financial issue at all. Nobody buys a home for purely economic reasons, though we often tell ourselves that’s why we are doing it. But by convincing ourselves buying a home is the only smart decision, we risk rationalising going into massive debt early in our lives, or spending way more than we would otherwise on a home, in the belief we are doing the right thing. I saw a comparison recently that went into the actual numbers comparing two hypothetical people: one owning a home, the other renting and investing in shares. The study was done in Canada, using all the relevant transaction costs and historical growth trends of property and stocks experienced there. The conclusions were interesting and illustrated several things. Firstly, after 25 years, the guy who bought a home, who stayed in it and paid off his mortgage, ended up accumulating $681 000 in net worth. The second guy, who rented the entire time and invested the extra take-home pay he had left after paying rent, ended up with $578 000 after 25 years. Open and shut case, right? It’s better to buy? Well, not so fast. No-one knows how well either property or shares will do — better or worse than their long-term averages — over a period of 25 years. So already trying to prove which is better is looking shaky. But even if you assume both assets stick to performing in line with their long-term averages, some small changes can turn out to make a big difference in outcome. For example, if the renter never bothers to start investing in shares, clearly they do much worse. Most people are aware of that, and some people even admit they bought a home because it was the only way to get themselves to save. But what most people wouldn’t guess is that all it took for the home owner in our example to do worse than the renter/saver, was for the owner to move house only twice in the 25-year period. If it’s unrealistic to expect people to rent and save, how realistic is it to expect most people today to buy one home and stay in it for 25 years straight? Most people don’t realise what a chunk transaction costs take out of your pocket when buying and selling a home. Our economies are heavily dependent on getting people to buy a home and take on debt and then slugging them with outrageous transaction costs. One final thing that I noted was that the comparison overlooked one critical aspect that most comparisons between buying versus renting and investing overlook. In the example, the home buyer put down a $50 000 deposit and then borrowed a lot of money to buy a house. The renter simply used their savings to buy $50 000 worth of shares. By taking out a loan to buy a more expensive asset, the home owner was using the power of leverage. Without leverage, let’s say you buy a $200 000 home versus $200 000 worth of shares: based on long-term averages the shares will grow more. But that’s not what the example compared. It compared a leveraged asset (the home with a mortgage) versus an unleveraged one. If our renter/saver had simply borrowed some money to buy more shares in the beginning, like our home owner borrowed money to buy more ‘house’, then our renter/saver would have come out far ahead. They wouldn’t even have had to borrow as much. When you realise that the passive returns from housing come largely from the leverage associated with it, it’s an eye opener. (This is not the only advantage of investing in property; property allows you to add value easily, but that’s an active investment strategy I’ll talk about later.) So whether someone who rents actually saves, whether they take out a small loan to give themselves some leverage, or on the other hand whether the home buyer moves or stays in one place for 25 years, all affect the outcome. It’s not a clear case of one being better than the other. But how realistic are either of these scenarios? People move all the time, and without a savings plan most people fail to save. And it’s normal to want different things at different life stages. Tying yourself down to a mortgage at a young age when the transaction costs of moving are so high may cost you important opportunities when you are young. However, as you get older and you’ve settled into a career or established a business, renting will be far less attractive than the security of owning your own home. Owning a home is not just a financial decision, it’s an important lifestyle decision. It’s a social issue, a family and community issue. It’s built into our psyches, but that doesn’t mean that we can’t occasionally choose to step outside the ‘normal’ box and do something different. If leverage is the reason for the success homebuyers have had, are we doomed to have to take on massive debt so we can get the leverage we need to grow our savings for retirement, now that we need larger and larger amounts to be able to stop working? Most people’s first experience ‘investing’ usually involves buying stuff. They buy their first home, or rental property, or even some shares. I’ll talk about why that is in chapter 9, and how we can break free of this ‘consumer’ mindset. But there are ways you can capture the profits from rising assets without taking on massive debt to buy them at all. And this is important to realise now that we know assets won’t always rise like they have during the past 30 years of unprecedented expanding debt. The reality is, that even in a booming market most of the gains occur in only a few months of the year (I’ll discuss this in chapter 10). In chapter 9 I’ll show you a technique you can use to earn income from your shares during those months of the year when they are going nowhere, instead of just paying out interest on your debt to hold them while they go sideways. Beyond just lessening the costs that come from taking on debt to buy and hold assets, what if we could get leverage without any debt at all? At the beginning of this book I shared with you a trade I did, based on my short-term view that the market would rise over the next few weeks. If I had simply bought shares to capitalise on that view, I would have had to buy $1.16 million worth of shares — just to make the same amount of money on the one trade that, instead, only cost me $24 000. Even if you had borrowed money to buy the shares, you would have had to come up with a lot more money than that, just for a deposit. (And that’s just the ‘long’ trade I did. The short spread I had done the previous day actually paid me money upfront — though I did have to have margin available to cover the position.) … even in a booming market most of the gains occur in only a few months of the year. Okay, so at first glance this stuff seems confusing. And I’m not entirely sure that that isn’t deliberate on behalf of the financial sector. But really, financial instruments such as options are not that hard to understand. At their heart, financial instruments are just pieces of paper that can be bought and sold, just like shares can be bought and sold. Not too long ago the idea of being a share owner was completely foreign to most people, but now, since we’ve financialised our economy and actively worked to erode people’s retirement savings, everyone who puts something aside for retirement has been forced to become an investor. This is not necessarily a good thing. But if you are being forced to become an investor, it pays to at least be a better informed investor. Options and other derivatives are essentially contracts that give people the right to do something, often the right to buy something, without having to own that thing first. You may have heard of how rich executives sometimes get paid in stock options? These options give them the right to buy shares in their company at a certain price — let’s say $10. If the executives can do a good job (or get lucky) and drive their company’s stock price higher, then these options will be worth more. Being able to buy something for $10 that has risen to $20 is very valuable! It’s like a discount coupon. A discount coupon is worth more the more it can save you. These types of options are called ‘call options’. How much would you be prepared to pay to have the right to buy Apple shares for $1 today? The other option that people are familiar with is when a Hollywood writer gets their script ‘optioned’. What that means is that a movie studio buys the ‘rights’ to a script for an amount of time. They don’t actually own the script, the writer still does. But for a period of time they have the sole right to make a movie out of it. If they don’t make a movie in that time frame the option ‘expires’, but the writer gets to keep the money they were paid and are free to sell another option on their screenplay to a different studio (this can be a good strategy to make money too: selling options. I’ll talk more about how you can do this later). This example is great because it shows that an option is a way for people to ‘reserve’ something for a period of time, to control something without owning it. The wealthy realise that there is more to investing than just ‘purchasing’ assets. Control is often more important than ownership. Once you understand that you can profit from something without owning it, you open yourself up to unlimited possibilities for making money without having to go into debt to do it. Once you understand that you can profit from something without owning it, you open yourself up to unlimited possibilities for making money without having to go into debt to do it. Here are some examples of ‘optioning’ something that don’t involve shares or options! Say you decide to buy a property, but the owner wants more money than you are prepared to pay for it. You can walk away or you could offer the owner a deal: you’ll meet their price if they will meet your terms. The opportunities for creativity in property are endless, which is part of what makes it such a great active investment. Understanding the importance of control and getting over the mindset of ownership is a big step towards freeing yourself from dependence on debt and buying assets in the hope they’ll rise in value. Finally, in the example I gave earlier, if I had bought $1.16 million worth of shares and they had gone down only 10 per cent in value, I would have lost more than five times the amount that I actually put out there to control the shares instead. Control, not ownership gave me the ability to put a small amount of money out there and potentially capture all of the ‘upside’ (if the shares had doubled in value I would have kept an extra $1.16 million) while limiting the downside. This is something Taleb calls ‘optionality’. Whenever you enter into any deal in business or life, you want to look for the opportunity to limit your downside risk, while maximising your upside profit potential. This was something Donald Trump learned early in his career. By personally taking on massive loans to finance his developments, when the market turned against him he ended up almost $1 billion dollars in debt. He famously joked to his wife that any old bum on the street was worth $1 billion more than he was at the time. While he was eventually able to turn it around, Donald learned an important lesson. Minimise your downside while maximising your upside. Many of the newer buildings that bear the Trump name aren’t even owned by him: groups of investors pay him to licence his name, so there is no downside for him, and he often takes a percentage of the upside as well. Control, not ownership. So to round out this section, what other ways can you think of to get leverage without debt, or to put a small amount of money out there in exchange for a large potential upside? Once upon a time, when higher education was cheap and skilled jobs were in high demand you could invest a small amount for education that would yield a large amount of extra earnings. While that is turning into a worse and worse deal, there are still community colleges or strictly vocational degrees that fit the criteria: less money, higher return. However, ‘qualification’ and ‘education’ are not synonymous; while colleges still hold a monopoly on granting pieces of paper, sites such as YouTube now make ‘education’ essentially free. Time is an asset, just like money. While you might still need the piece of paper to get a job in the corporate world, all the skills you need to start your own business are freely available. You can teach yourself almost any human skill you can imagine for next to nothing if you have the drive. The final way to get optionality is time. Time is an asset, just like money. You can invest it and it doesn’t have to cost you anything. That’s the ultimate definition of limited downside: risking losing nothing but your time. Finding the time to learn a new skill, start a small business, teach yourself to invest, and so on, is possibly the best investment you can make. Which is why I say if you want to be financially free you need to get free first — and this may simply mean you need to buy yourself some time back first. Once you realise you can make money from assets without owning them, you can actually start to make money from assets that are falling in value too! We’re so conditioned to buying things that we hope will then go up in value, that most people don’t realise that you can make money when things go down in value too. You can ‘short’ stocks, or even buy contracts like the options I described above, that make you money when stocks go down in value. Instead of giving you the right to buy something at a certain price, a different type of option — called a ‘put option’ — gives you the right to sell something instead. If you can lock in a price to sell something for, say, $10, and that thing falls in value, then the contract you have is worth more than when you first bought it. If that sounds complex, don’t worry, you’re already an expert with this type of complicated financial product … after all you have insurance, right? An insurance contract is a piece of paper that you pay for, that allows you, for a certain period of time, to ‘sell’ an asset at a certain price. Most of the time the insurance contract expires worthless: you paid a premium, but eventually when the year ends and your house hasn’t burned down or you didn’t crash the car, the contract is worthless and you have to pay a premium again for the next year — and you’re happy about this! However, if your car did rapidly fall in value (because you crashed it) your insurance contract would be ‘worth’ a lot more. You would call up the insurance company and ‘cash’ it in for a lot more money than you paid for the contract initially (your premium). When it comes to shares, put options and other similar derivatives work the same way. You can buy them to insure shares that you own, or you can simply buy them with the view to selling them later for a profit, if the shares in question fall in value. Wouldn’t you like to have been able to insure the price of your retirement portfolio before — or even during — the stock market crash of 2008? It’s not like it happened overnight either — it went on for over a year. Why is it we are all being nudged/pushed/forced into becoming investors now, but no-one tells us we can insure our life savings? It’s almost like it’s more profitable to sell us managed funds than it is to teach us the skills to protect our wealth. During the 12 months of the GFC not only was I able to protect the value of my shares, but I was able to make more than $50 000 per trade as volatility soared and the markets fell. When the market finally bottomed, because I didn’t believe in taking on much debt to buy assets in the first place, I wasn’t eaten alive by the margin calls that forced so many others to sell their shares at the very bottom. Better yet, I had cash to invest. You don’t need to be dependent on assets rising or falling. While it’s important to know that there are ways you can get around the financialisation of our economy by using more sophisticated tools than the average person, in a way that’s adding complication to an already overly complex problem. Since when did we all have to become investors just to stay in the same place? This last step is the step that really excites me. Most people, if they ever get around to it, will only own assets. Some will learn how to control assets. But real freedom — in contrast to going into massive debt just so you can buy assets and then pray they’ll go up — comes when you realise that you don’t need assets to do anything at all. You can create assets yourself. Another way to think about creating growth could be called active growth. Active growth is the opposite of passive growth. Passive growth is where you work hard at a job, pay tax, then buy an asset and hope that it will rise in value passively. The era of easy passive growth may be coming to an end. Active growth is where, instead of being dependent on the market going up, you guarantee your profits upfront by creating equity. (Getting profits upfront is important, not just to free you from dependence on passive growth, but also so you create the capital you need to do the next deal, making it easier to take the next step — getting freer so you can get freer again.) With property investing, neither ‘passive growth’ nor ‘passive income’ make getting your next property any easier straight away. (See chapter 14, where I introduce the term ‘Freedom Escape Velocity.)’ In the next few chapters I’ll explore the importance of working for equity instead of just income, but for now let’s look at a few examples. Doing a renovation on a property is one way you can actively raise the value of a property, so regardless of whether the market booms or not you can build in equity straight away (if you’re smart about it and use this strategy at the right time). However, while renovations are an example most people are familiar with, they may not be the best strategy, depending on your current market. There are many better ways to create equity that the average person may be less familiar with. Bargain purchases are one. Developments are another: the best development transforms something from one category into another that has higher market value. Splitting blocks, or securing a re-zoning are examples of this. Even bargain purchases can be used to get active growth. You can’t control what the market will be prepared to pay for a property, but you can control what you pay for it. Strategies for buying ‘below market’ are an essential way to guarantee you some profits upfront, regardless of what the market does. (I’ll share an example of a bargain purchase made using an awareness of cycles in part III.) Lastly, while most people are more familiar with shares or property when talking about assets, there are two assets that give you the most leverage and the most potential to lock in active growth upfront. Most people only consider going into business if there is the possibility of making more money or income than at their current job. But the real value of a business is that for the same number of hours you work, you not only are getting paid income, like in a job, but you are building an asset too. Your job is not an asset. Retire at the end of a life working for someone else and your income stops and that’s it. Retire after building a business and your income may continue if you’ve leveraged yourself out of the business; but even if not, you’ll have an asset that has real value too. On top of that, depending on when and how you sell your business, you may be able to bank up to $6 million tax free too (more on this later). Finally, the second asset that we can actively ‘create’ that nearly everyone overlooks, is yourself. Most people are pretty passive about how they grow this asset — we go to school, let others train us for the job market, then any other ‘upskilling’ we do is often left up to our boss. But by taking charge of actively growing yourself — learning new skills, even taking up new hobbies — you can exponentially improve your wealth-building ability. One skill or hobby that you enjoy doing in your retirement might earn you only a couple of thousand dollars a year, but as we saw earlier, it could free you from having to save over $100 000 in retirement savings. That’s one way to end the ‘addiction to assets’ and free yourself to retire that much sooner. Debt can create a horrible feeling. It becomes one of those things that we just don’t want to think about. We want to ignore the situation. Unpaid bills. Letters in the mail that you are afraid to open. You throw them in a pile and they glare at you. Once the pain has built up enough, people can be motivated to take action. And the results can be amazing. Plenty of books have been written on how to get out of debt, and who needs to explain why? The pain is clearly motivation enough. Like putting your hand on a hot stove. But who wants to have to be motivated by pain alone? Or to only be able to dig deep when your back is against the wall? We have all experienced the amazing amount we can get done when there is a deadline looming. For ages beforehand, we may not get much of anything done, then within the space of a night we can do more in a few hours of pressure than we could in the weeks prior. … who wants to have to be motivated by pain alone? When people do face and start tackling their debt, they often experience a surge of energy — a new sense of purpose. They are tackling something that was causing them real and immediate discomfort. They are making progress that they can see, and that sense of getting free from something is a powerful motivator. But what happens after that? The crisis has passed. The immediate pain has gone. Traditional financial advice may be good at providing the tools you need to get out of debt but it’s not great at tapping into the motivation you need to get rich. I’ve noticed with those in debt that it’s not unusual to tap into the desire for freedom when you are being crushed by something. Freedom is such a powerful motivator precisely because it is something we usually only ever tap into when we’ve lost everything else. It’s only after we’ve lost everything that we’re free to do anything. Tyler Durden in Fight Club by Chuck Palahniuk But while the average person may not really value freedom on a day-to-day basis, the average person doesn’t end up rich either. So how should we approach getting free of personal debt? Let me first say that there are a lot of great books and resources that are full of tips and techniques you can apply when you’ve made the decision to free yourself of personal debt. Things like calling your bank and asking to speak to the debt resolution team. Most countries have a banking ombudsman and have mandated that consumer lending be accompanied by many safety nets — for example, you may find that your bank is willing (or obligated) to freeze the interest on your credit cards for a period of time, or roll your balance into a card with a lower rate, or eliminate your fees if you contact them for help. These are all things that you should take advantage of immediately, but how should you go about actually getting out of debt? There are several schools of thought on this, but I’m going to break them down into two categories: the mathematically efficient, and the actually effective. What do I mean by that? Well, some financial planners advocate for a payment strategy called the debt snowball — Dave Ramsey is a famous proponent of this strategy. The way it works is, let’s say you have three personal finance debts: one credit card with a $500 balance on it, another card with a $5000 balance and let’s say a personal loan or a third card with a balance of $10 000. Now let’s pretend that the largest amount, $10 000, has the highest interest rate, while the smallest amount has the lowest interest rate. How should you begin paying off all this debt? You probably have to pay a minimum amount towards each of them each month, but should you then direct, say, 10 per cent of your salary to pay a little off each of the loans each month? Or should you pay off one of them first while making your minimum payments only on the other two? The debt snowball guys say to pay off the smallest amount first because that will create emotional momentum. Once you’ve paid off the small amount, you’ve eliminated one debt entirely, and can now direct the 10 per cent of your salary that you’re using to pay off your debts towards the next card, but you can also add to that the minimum monthly payment you were paying off on the first card too, creating a ‘snowball’ effect. On the other hand, the strict, mathematically efficient approach would say no, you should start to pay off the amount that has the highest interest rate first because that makes the most financial sense, even if it’s the larger debt and will take much longer to pay off. Who’s correct? Well, surprise: it’s not the mathematical literalists. While they are correct that paying off the loan/card with the highest interest rate is the most efficient way to go about it, and will save you money overall, it will only save you money if you actually go through with it and keep paying off your debt. Testing the debt snowball technique A Kellogg School of Management study with over 6000 participants was conducted to test just this hypothesis to see whether the debt snowball technique worked. They found it was more effective to have people pay off the smallest amount of debt first, as people who did that were more likely to persevere and pay off all their debt than those who didn’t. This goes for other tempting strategies too. Why wouldn’t you just roll your personal debts into your mortgage if your bank lets you? Surely paying only mortgage interest of, say, 5 per cent beats paying credit card interest of 17 per cent? But even if the interest is higher, if you actually pay off your credit card debt, you’ll come out miles ahead of where you would be if you simply added that debt to your mortgage at a lower rate and it never got paid off. And if you do that, what’s to stop you racking up credit card debt again? In trying to be efficient, people sometimes miss the chance to be free. And it’s getting free that makes you rich. In trying to be efficient, people sometimes miss the chance to be free. So what’s the lesson? Being mathematically inefficient is okay if you’re tapping into the right motivation. And without realising it, the debt snowball guys were tapping into the power of Freedom First. Getting free first, in this case ridding yourself of one debt entirely, helps you to feel freer. And feeling freer is something you can begin to value. People spend more time ‘escaping’ from work than they do trying to get free from it. Matthew Klan. Freedom First tells us there is a difference between escaping and getting free. People who want to escape from pain are often powerfully motivated — in the short term. But wanting to escape from prison, and being able to stay free once you get out, are two different things. There’s no point getting out of prison if you’re only going to end up back inside again. Getting free of debt isn’t about doing the right thing after doing the wrong thing. You can do the right thing and still end up crushed by debt. We saw this with the housing crash: people who watched their expenses, avoided consumer debt and took on nothing but ‘good’ debt in an attempt to grow their wealth by adding leverage ended up financially ruined. Which is why we need to stop defining debt as ‘good’ or ‘bad’, and instead ask, Does this make me more free, or less free? The reason to get free from debt, is so that you can do more. Having debt hanging over your head is not just painful, it’s restrictive: it fills up your mind; it ties you to income to service it; and it stops you from breaking away, creating and trying new things. When you start to really value your freedom, you’ll come to see ‘getting out of debt’ as not just a way to avoid pain, but as a way to free up your mind, as well as a way to give yourself more choices. This is why I suggest doing something else that’s also mathematically inefficient while you’re paying off debt … Save for your freedom. You can start saving while you’re still paying off your debt. At first this makes no sense — why would you put money into a savings account earning nothing, when you could be using that money to pay down your debt, which could be costing you 12 per cent or more in interest? There is wisdom in achieving something positive while undoing something ‘negative’: it helps you to transition away from an ‘escaping’ mindset to a ‘getting free’ mindset. If you wait until you have paid off all of your debt before you start to think of ways to create, to invest, innovate or start a business, you will be waiting a long time. If you start saving for yourself while you are paying off debt, your mind is better able to start thinking of all the positive changes and choices you could make. What if you could stop thinking about your debt straight away — even before you’ve paid it off? Free your mind from debt, before you free your balance sheet from debt? In part III, I’ll show you not only how to do that, but also how to free yourself from ever having to worry about bills, groceries and all those other short-term expenses that fill up our minds and stop us from working on something bigger. Obviously, getting out of debt or avoiding debt can make you freer; in fact, it’s also one of the many ways that getting freer directly makes you richer. Every dollar of personal or credit card debt you pay off is like earning 17 per cent on your savings, after tax. Some people find that the act of saving for something rather than buying on credit not only saves them interest on every purchase, but also means they buy less stuff that they end up not really wanting. Which may be one of the biggest advantages of going debt free. However, Freedom First isn’t about going without. It’s about being free to have everything you really want. The real cost of debt is not the interest. Using debt causes you to miss the relationship between purchases and costs. The real cost of debt is what you’re tempted to give up when you spend now and pay later. I’ll talk more about the relationship between how we earn and how we spend in chapter 9. If debt is bad because it can cost you your freedom, then there is one trap worse than debt that no-one in personal finance is talking about. And it’s the reason that we get trapped into using credit in the first place. Credit exists. The genie is out of the bottle. And he’s a bad genie. But what tempted us to listen to him in the first place and believe that he could grant all our wishes with a quick ride on his magic plastic card? Before we had the temptation of easy credit we had the temptation of safe, secure, regular, predictable income. Before we became slaves to credit cards, we had already become slaves to pay cheques. Without the illusion of reliable, repeatable payments coming in, we would have never felt tempted to take on the debt that locked us into regular payments going out. And now the whole world is stuck in the Income Trap, addicted to the regular hits of income, just as the supply is starting to dry up … A Quick Recap Debt is a big part of what traps us into short-term thinking and working a job for life. We need to evolve beyond thinking in terms of ‘good debt/bad debt’, and think about the costs of debt, especially in terms of our freedom. You don’t need to slave your life away, servicing debt in the hope that you will one day have enough assets to retire — you can get leverage and create wealth without debt. You don’t need to be dependent on the market always rising, and you can even create assets yourself. Getting free of debt isn’t about ‘righting a wrong’; it’s about giving yourself more choices.The illusion of stability at one of the most unstable times in history
The end of passive growth?
Four levels of recovering from dependence on debt and ‘addiction to assets’
Level 1: develop a new view on debt
New views on debt
Level 2: leverage rising assets without debt
Control but not ownership
Optionality
Level 3: make money from assets even if they are falling in value
Level 4: don’t be dependent on assets rising or falling — create assets!
Own → Control → Create
Property
Business
You are an asset
Getting free of debt
Escaping versus getting free
