All Debt Is Not Equal: Oppressive, Working, and Enriching Debt

Before we even begin our quest to explore another path, we have to cover an essential ground rule: There are different kinds of debt. The different types of debt can be seen in Table 2.1.

Debt has a bad name, and I blame oppressive debt. It should be avoided at all costs. It is characterized by high interest rates, amortization schedules, and typically no tax deductibility. It is what most people think of more generally when they think of debt. It makes you poorer in real time, and it's hard to get out from under once it starts building up.

I consider anything with a rate higher than inflation plus 6 percent to be oppressive debt—the trans-fat of debt. In the United States in late 2016, this would be any debt that has an interest expense over approximately 8 percent and certainly anything with a rate over 10 percent. If you have this type of debt, pay it off. This is not the type of debt I am talking about. Oppressive debt doesn't allow you to work both sides of the balance sheet.

If you have a mortgage, student loan, or small business loan, you are using working debt. Generally, this is debt tied to a specific purpose and has a lower rate—typically under inflation plus 6 percent and ideally closer to inflation on an after-tax basis. In the United States in late 2016, this would be debt that generally has an after-tax cost between 2 percent and 8 percent. The Steadys in Chapter 1 used working debt for their mortgage.

Enriching debt is debt that you choose to have yet could pay off at any time.¹ It's at a very low interest rate, perhaps close to the rate of inflation, and you also have the money in the bank to pay it off. This type of debt may allow you to capture the spread, meaning over time you may have the opportunity to make more money on an investment than it costs to borrow the money.

For example, if you're paying 3 percent on a loan that enables you to leave investments that are earning 6 percent intact, you're actually earning 3 percent. Consider the Radicals from Chapter 1, who kept a mortgage when they retired even though they could pay it off at any time.

Paying Down Debt Gives You a Return Equal to Your After-Tax Cost of That Debt

How does this work? If you pay down credit card debt at 19 percent, you get a 19-percent return. If you pay down a small business loan at 8 percent, you get an 8-percent rate of return. Paying down a fully tax-deductible mortgage at an interest rate of 3 or 4 percent, however, gives you a rate of return of only 2 or 3 percent. In some instances, due to a combination of low rates and tax benefits, paying down student debt could give you an after-tax return of zero!

This is a stunningly simple fact that many people fail to consider with respect to debt. If you feel that your investments have a high chance of doing better than your after-tax cost of debt, then there can be value to having the debt. If you feel that your investments are likely to do worse than your after-tax cost of debt, then you might want to consider paying down debt.

The key here is the time horizon. Your time horizon is the rest of your life—and potentially longer if you have family you are trying to take care of. This isn't a question of beating the cost of debt every minute, hour, day, week, year, or even every three or five years. It is a question of beating it on average and throughout time. If you believe there is a reasonable chance the cost of debt is below what you might average in returns over the next 10 years or longer, then there may be value to debt. If not, then you should consider paying down that debt.

Looked at through this lens debt becomes more interesting. There can be times you might want to consider higher debt ratios and there might be times you want to consider lower debt ratios. Unfortunately, most people are overconfident and borrow too much in good times and are quick to eliminate debt in bad times. We will discuss these strategies in more detail later but for now, remember that paying down debt gives you a rate of return equal to your after-tax cost of that debt.

Sh*t Happens—Value Liquidity

Cash is a form of insurance. Companies often have both accessible amounts of cash and outstanding debt. The cash almost always has a rate of return less than the cost of debt, thereby earning a negative spread. Why don't they just use the cash to pay off their debt? Because having cash and debt enables the company to better run both offense and defense with a range of outcomes in mind. Apple is a company many people, including me, admire. They have billions and billions of dollars in cash. They also have billions of dollars in debt.² They do it strategically because they value the liquidity, flexibility, and tax benefits associated with the debt. This is an essential concept for individuals as well.³

Many of us are familiar with life insurance. I have some so there's money for my kids if I die. This is good for them, but doesn't do a lot for me as I'll be dead. I hope my passing is a low-probability event, yet many young professionals buy insurance to protect against this risk. I'm not against this—I'm a client—but it's interesting so many of us pay a lot of money to protect against a relatively low-probability event.

A higher probability event is that at some point in life you could be unemployed, in an accident, made homeless by a disaster, decide to move, or have a health scare. Bad things can happen to all of us. Access to cash can help.

Consider Diana and Terry. Terry is in a rush to pay off all of his debt. He has a $500,000 house and a $400,000 mortgage. He directs all of his cash and savings toward paying down his loan and eventually gets it down to $300,000. Terry loses his job. He can't access any of the money in his home unless he sells it. And he doesn't have any income or cash to pay the mortgage.

Diana values liquidity. She puts $100,000 down on her house but directs all of her cash and savings toward building up $100,000 in cash—cash that she just holds in a money market, savings account, checking account, or under her mattress. Just cash. When the crisis hits, Diana has $100,000 accessible, which she uses toward covering bills and supporting the family. She has flexibility if she needs to move and is in a position to evaluate her choices and make her next job choice prudently. Diana can survive.⁴

Never underestimate the power of liquidity. Having $10,000 to $50,000 of liquidity increases your ability to survive shocks. Having $50,000 to $100,000 of liquidity enables you to potentially thrive through shocks. Having $1 million or more of liquidity is a powerful place that relatively few people reach.

Too often people say, “Well you can just use your home equity line of credit.” Maybe. A home equity line of credit (HELOC) is a very powerful tool I recommend everybody carefully consider. If there is no cost to set it up and no cost to having it open, then it can be a great standby emergency fund. If it has a lot of costs associated with it, you may want to think twice.

Many people were surprised during the financial crisis of 2008 when HELOCs were reduced or revoked.⁵ They thought they had a safety net, but it was yanked out from under them when they needed it most. If you feel comfortable putting your safety net in the hands of a bank credit committee, consider this an option. If you like to control your destiny independent of others, cash is king. In a perfect world, you should have both cash and a HELOC. We will talk about how much cash as we move through the different phases of L.I.F.E. later in the book.

Yes, You Can—Save

Saving is hard for a lot of people. Trust me, if you are saving less than 5 percent, I get it. I once lived paycheck to paycheck and with a lot of debt. I had a great job but $5,000 on my credit card and $0 in my checking account. If you are in this camp, I offer some tools to help you out of this trap as we move forward through the different phases of L.I.F.E. After all, paying off debt is a form of savings and, as I discussed above, your rate of return in paying off debt is exactly equal to your after-tax cost of debt.

How much should we save? My ideal target is at least 15 percent. You will find that saving at 20 percent gives you more freedom, flexibility, and less anxiety. You need to save at least 10 percent or you need to plan to work for a very long time. On the flip side, unless you expect a very short career (such as a professional athlete), then I see little value to saving more than 30 percent of your income. We want to find the balance and enjoy life, too.

If you are not at this savings level today, then I will outline a glide path to gradually ramp to this level. But you are wealthier than you think. If you make more than $54,000 a year, you bring in more than half the households in the United States.⁶ If you make more than 50 percent of the people in your community, there's no reason that you cannot save 10 to 20 percent of your income. This savings rate is the foundation to your glide path. If you make more than half of all Americans but aren't willing to adopt a glide path to move to where you save at least 10 percent of your income, then put this book down right now.

What counts as savings? I define savings as contributions that improve your net worth. You can improve your net worth by increasing your assets or reducing your debt. So in addition to normal savings from cash flow, I also count retirement plan contributions, employer matches, and payments toward principal on outstanding debt (not interest!).

For example, Emily and Rob make $100,000 per year. They save $10,000 to their 401(k) and get a 4-percent match from their employer, making their retirement savings $14,000. If they also save $5,000 into their checking account, and pay down $5,000 of principal on debt, their total savings would be $24,000, or 24 percent of their income.

A couple of important clarifying points:

1. As we move forward, I will assume a savings rate of 15 percent. If you have a high level of debt (especially student debt or credit card debt), then it may take more time or a higher savings rate to accomplish the glide path.
2. I encourage you to exclude car payments as a part of savings. For example, you have a $30,000 car loan for five years at 5 percent and are making a monthly payment of around $566. Some of that payment is going to principal and some is going to interest. One could argue that by paying down the car you are reducing debt and increasing your net worth. The problem is that the car is also depreciating and it will be worth less in the future. To factor in the principal payment, you would also need to factor in the depreciation to look at the net savings. If you understand what this means and it sounds like how you would like to approach things, then I'm comfortable if you include the principal payment net of depreciation in your savings figure. However, if you want a simpler, straightforward, conservative, and easy approach, then I recommend you exclude your car payment(s) from the formula, even if you are paying some toward principal.

Compounding Matters—For the Upside and the Downside

Compounding matters in both the upside and the downside. In other words, the financial decisions you make have the potential to exponentially help you, but they can also exponentially hurt. This is an essential pillar to The Value of Debt. Let's start by looking at the bright side of compounding and then I will share a personal story about the dark side of compounding.

Consider the following story illustrating the bright side. A farm worker responds to an ad seeking someone to do heavy manual labor during the long, hot days of August. The ad says, “Name your own fee.” The worker proposes the following: “For the first day, to demonstrate my good will to you and show you how hard I work, you can pay me one penny. Starting the second day, and every day after that, I ask that you double the amount I was paid the previous day. The second day I will get two more pennies on top of the first penny for the first day, and the third day I will get four more pennies added to what I've already been paid, and so on. I start with just a penny a day, and all you have to do is double that penny every day for the next 30 days, and we'll be done. Sounds pretty good, right?”

You're a smart boss and decide to check the math. Because of the power of compounding interest, by the end of August, you would owe your employee 2,147,383,647 pennies, or almost $21.5 million (see Table 2.2). Everyone in the accumulation phase should understand that power.

The Past Is the Past; Focus on the Future

Whenever I'm tempted to do a forensic accounting of my exact contributions and matches to my savings to determine my rate of return for the past 15 years, I stop myself. What exactly will that tell me, and what will I do with that information?

Too many people focus on where the money came from (inheritance, earnings, real estate, etc.), what their net worth used to be, or what rate of return they have earned. Your spending, habits, and returns from the past are all irrelevant. You can't change anything in the past. You can do things to change your future, and that's where you should focus.

When considering the future, keep two things in mind:

• Nobody knows the future. It will probably be balanced with good and bad.
• We are not entitled to anything.

Too many people think they or others know the future. Nobody knows what the price of oil, gold, or a Coke will be in two years, let alone 5 or 10 years—not you, not the talking head on TV, not the economist in the newspaper.

There is a fundamental difference between those who think they know and those who know they don't know. Those who know they don't know are prepared. You can't predict a crisis, a natural disaster, or a bear market. The only way to be prepared for an unknown future is to have enough liquidity.

I have seen too many people who believe bad things won't happen to them. They are protected by their education, health, wealth, family, or title. They believe it will be easy to get a new job and overcome obstacles. If you feel this way, good for you. This confident attitude makes it easier to overcome obstacles. But you can't pay your bills with confidence so tread cautiously. Many of my friends who felt entitled have been greatly disappointed. No one knows the future and no one is entitled to anything.

Behavioral Economics Matters

Economics typically starts with the assumption that you are disciplined and rational. The problem is we set a plan and then life comes along with a bright, shiny object to distract us.

My ideas present a potentially slippery slope. I will show you ways to minimize your house payments so you can increase your savings, but if you blow the money you save on your mortgage you will be unprepared for crises at best, unable to retire or enjoy life at worst.

Consider Jeremy. He wants to buy a home with a $300,000, 15-year amortizing mortgage at 3 percent. His monthly payment would be a little more than $2,000 per month. He realizes he is likely to live in the property for only five years and instead chooses a five-year, interest-only loan at 4 percent for a monthly payment of about $1,000 per month. Jeremy gets to live in the same house, but he has $1,000 per month cash flow difference. I assume if you could afford to make the $2,000 per month payment but choose to make the $1,000 a month payment the extra $1,000 per month goes toward increasing savings or reducing other debt—NOT to spending.

Too often, people don't do this. If they have an extra $1,000 per month of cash flow, they spend it. I assume you are able to handle the power of these ideas. This is a big assumption. If you are prone to spending money and are unable to save extra cash, then you will need to consider alternatives. Amortized mortgages are effectively a forced savings program. Before implementing my ideas, ask yourself if you can handle the responsibility and discipline they require.⁷