Zero Oppressive Debt Is Valuable

The average U.S. household carries $15,310 in credit card debt, which totals $712 billion. According to NerdWallet, “Consumers and lenders are reporting vastly different credit card balances—to the tune of more than $415 billion as of 2013—likely because consumers are underreporting their debt. This means that Americans claim to have less than half of the debt they actually have.”²

What is amazing to me is how many people have debt on a credit card and debt on their house, yet are paying down on their house. If your mortgage is at 4 percent and your credit card is at 14 percent, then by deemphasizing paying down your mortgage and by paying down credit card debt, you can save 10 percent per year. If you have $15,000 of debt, this simple step is worth $1,500 per year. Over a 40-year time period, this can be worth over $60,000.

Is Debt Valuable if It Costs Nothing?

If conventional wisdom says that all debt is bad, is debt that costs zero bad? Let's test it compared to the option to save over 35 years at 4 percent. If it passes the test at 0 percent, then we can ask tougher questions, like how much we are willing to pay for debt.

Thirty-five years may seem like a long time, but life expectancy is changing. If you are 35 today, you can easily reframe retirement toward age 70. Of course it would be great to be able to retire earlier, but I will look at the glide path as a 35-year horizon from when you start the Independence phase. If you clear the Launch phase by 30 and have your heart set on retiring at 65, then you still have a 35-year time horizon.

Let's start with Brandon and Teresa. Remember, they are 30 years old making $60,000, the approximate average household income. They buy a $240,000 house, with a $195,000 mortgage. Their savings rate is 15 percent.

The no-debt camp would recommend Brandon and Teresa direct all savings to pay off the mortgage. To be extreme, let's say that even debt with no cost is evil in this view. Brandon and Teresa get a mortgage at 0 percent and decide to rush to pay it down.

In the current example, the savings rate of 15 percent is $9,000, which means that the mortgage would be eliminated in $195,000 / $9,000 = 21.6 years.

When they are 51.6 years old they have a party and celebrate by burning their mortgage documents. Unfortunately, they also have zero savings and are 51.6 years old.

Let's assume they start saving and their savings grows at 4 percent until they are 65 years old. They will accumulate $159,000 in total savings. It turns out that the average 60-year-old has about $172,000 in retirement savings.³ So, you could embrace the no-debt mantra, save, and perhaps be in line with to slightly ahead of above average.

The problem with this outcome is that they “did everything right” yet they fell short of the goal line. They found the cheapest mortgage, one that cost zero in our extreme example, they paid it off, and they had a rate of return of 4 percent during their investing life. There is virtually no way this family can retire with the same lifestyle. Keep in mind, 4 percent of $159,000 is less than $10,000 per year. They are 70, undersaved and dependent on Social Security.

What if their rate of return was higher, say 8 percent? They would have $215,000. What if their rate of return was 12 percent? They would have $296,000. In the best of cases they are likely to have between $135,000 and $300,000. Think about this for a minute. If Brandon and Teresa had a 0-percent mortgage and follow conventional wisdom and average an improbable 12-percent return per year, they would accumulate less than $300,000. While this is impressive, they are well short of having a comfortable retirement.

What if they followed the L.I.F.E. path I have outlined? By embracing the ideas of the book, they would have built up assets early rather than focused on paying down debt. What if instead of following conventional wisdom they directed the $9,000 of savings into an investment that paid 4 percent? At the end of 35 years, they would have built up about $685,000!

If they have a 4-percent rate of return on the $685,000, they would have about $27,000 of income, plus Social Security, which would be estimated to be approximately $26,000. Their total income is $53,000!

Importantly, they no longer have the expense of their savings, which was $9,000 per year. $60,000 – $9,000 = $51,000. They actually have more income than they had when they were working.

What if they don't trust Social Security? Incredibly, if they worked until 70, their assets would grow to almost $900,000 and their Social Security would be $36,000 per year.⁴ Even if benefits were significantly reduced, they could retire with significantly more income than the no-debt family.

Granted, the no-debt family no longer has a mortgage, and the other family still has a $195,000 mortgage, but they have more assets.

We just took the average American family—that had no chance of being on track for retirement—and gave them a comfortable retirement using conservative returns, by embracing the Value of Debt in Building Wealth.

To be clear, by embracing a balanced approach to building wealth, Brandon and Teresa with a 4-percent return and a 35-year time horizon, have double the money of somebody who averaged a 12-percent return for a shorter period of time. You cannot—and should not—underestimate the long-term power of compounding. We all know it; the tortoise wins the race. In fact, consider that if Brandon and Teresa averaged an 8-percent rate of return, they would have $1.7 million. At 12 percent, they would have an astonishing $4.8 million. For Brandon and Teresa, the single biggest determining factor in their ability to retire is the decisions they make with respect to debt. Return is perhaps the least important factor in determining how much money they will have at retirement.⁵

There is considerable value to saving early. In the average American family, we just showed there could be well over $400,000 of value. If you make $60,000 and are saving $9,000, that is a big difference. And if your income is higher, the difference is even more impactful in terms of dollars.

Most people pay off their good and bad debt early and save later. They should do the opposite: Keep the good debt, build up assets early, and harness the power of compounding. You can always pay down good debt later.

However, we assumed things like a 0 percent cost of the mortgage and no inflation and we looked at a constant-rate-of-return environment. These are all unreasonable assumptions so we need to drill down further. We are right back at Chapter 1 and the examples of the Nadas, the Steadys, and the Radicals. With simple assumptions, it is easy to see the hypothetical value of debt, but what about the real world? From here, let's pull from the foundation we have built to answer many commonly asked questions:

• What happens if borrowing costs are higher?
• What if investment returns are higher or lower?
• What about the impact of the savings rate?
• What are the tax implications of the strategy?
• What if the mortgage interest tax deduction goes away?
• What about children/college savings and debt?
• What about debt service coverage ratios?

It is, of course, impossible for me to 100 percent prove without a doubt that debt can add value to you and your family. Obviously, it is possible that debt could destroy value. So the key question is, what do we need to believe to know that the glide path illustrated is better than conventional wisdom?

What about Borrowing Costs?

From a big-picture perspective, your borrowing costs are what they are and will change throughout time. On an absolute basis, you want to consider if you think your returns are likely to be higher than your borrowing costs over a long period of time. In the book, I have referred to borrowing at a rate close to inflation. If your borrowing costs are inflation, and your rate of return is inflation + 4 percent then over a long period of time, debt will add considerable value. So, can we borrow at a rate close to inflation?

Interest rates in most developed markets and in the United States are at or near generational lows.⁶ In July 2016, 30-year fixed mortgages in the United States were approximately 3.5 percent and five- and seven-year adjustable rate mortgages were generally around 3 percent.⁷ In the current tax environment, many borrowers receive tax benefits that range from 20 percent to 40 percent, depending on their income. Borrowing costs after taxes generally hover in the 2 to 3 percent range.

Although these rates are very low compared to historic standards, there is another side of the coin. Money market rates are generally under 1 percent and many are closer to zero.⁸ While inflation was around 1.6 percent in 2014, it was about 0.5 percent for 2015. Cash, relative to mortgage rates, is at a negative spread. Importantly, borrowing costs, even after tax, are about 2 percent higher than inflation. This means that currently, even though rates are low, borrowing costs are higher than inflation and cash is paying less than inflation. In this environment, it may be hard to capture as much of a spread. But what about historically?

Table 6.2 lets us take a step back in time and look at mortgage rates compared to money market rates and inflation.

If interest rates are high and money market rates fall, you could find yourself in a position where you have a high borrowing cost and a lower return on investment.⁹ For example, if you were in a mortgage in 1980 and didn't refinance by 1995, you could be paying 12.7 percent (8.9 percent after tax) on your mortgage and receiving 5.5 percent on your cash. A negative spread! A declining rate environment could make it hard to capture a spread if your interest cost is fixed.¹⁰ The solution to this is to refinance the debt to a lower rate, which is what millions of Americans have done over the past few years.¹¹

What about the opposite scenario? What if you borrow when rates are low and then over a long period of time they move higher? What is interesting is that borrowing money can be one of the best ways to express a view with respect to interest rates. For example, if you borrow money for 30 years at 3.5 percent and money markets move to 6 percent, which is below average from the past 45 years, then it would be possible to capture a significant spread and just be in cash!¹²

I am in no way suggesting this will happen. It is my opinion, rates could stay lower longer than most people think and do more unusual things than most people think. But that is just my opinion, and I have no idea what will happen with interest rates—and it is my opinion that nobody else knows, either.

We can identify two things:

1. Interest rates are just a function of the economic environment we are in at any given time. High rates are not bad, low rates are not good. While mortgage rates looked awful in 1980, cash paid the same and long-term bonds paid even more.
   1. It would have been easier to capture a spread in 1980 with interest rates at high levels and stock market valuations near generational low levels.
   2. Today, low rates may make an illusion that it is easy to capture a spread. It is possible that future returns in both stocks and bonds have been pulled forward and that for investors in developed markets, it may be hard to capture a spread, even though rates are low.
2. On the other hand, if you were to lock in rates for a long period of time and try to capture a spread, you might try to do so with interest rates near generational lows, like they are in the United States and in many markets around the world in mid-2016.

Let's revisit the question: Can we borrow at a rate equal to inflation? Over the past 30 years, it appears that if we were borrowing long term (on a 30-year fixed mortgage) and comparing to short-term inflation, then no, we cannot. This includes today where even factoring in tax adjustments, borrowing costs for 30-year mortgages, even though they are at generational lows, are averaging higher than inflation.

However, this is misleading because it is comparing long-term fixed mortgages to short-term inflation. There are floating-rate mortgages that have a cost of approximately LIBOR + 2 percent. These rates change on a monthly basis. LIBOR is the London Inter Bank Offering Rate and is the rate at which banks can borrow and lend from each other. Since 2008, LIBOR has generally been between zero and 0.5 percent.¹³ This means that there is a product through which an individual can borrow at a rate closer to 2.5 percent in the current environment, which can be close to 1.4 percent for borrowers in a high tax bracket. This is stunningly close to inflation. The risk with this product is that if central banks, like the Federal Reserve, raise interest rates, and if LIBOR rises alongside, which is what is generally anticipated, then borrowing costs will rise as well.

As was highlighted in Chapter 5, simply looking at the past 30 years may be misleading. It is a single economic environment in which interest rates went from generational highs to generational lows. While inflation may stay lower, longer than many people anticipate—and while the world continues to battle deflation—there is no question that we are at a different beginning place. The spreads that one needs to capture looking forward are starting from near all-time lows in the United States, Europe, and Japan. From these levels, on an absolute and relative basis investors need to capture a spread lower than ever before.

Therefore, we can conclude that borrowers following the L.I.F.E. glide path have an interesting choice between borrowing at a floating rate that is near inflation and borrowing at fixed rates that while higher than current inflation, are lower than historic inflation and starting at generational and in some cases—all-time lows.

It is important to note, in the examples above, we are comparing borrowing costs to inflation and to returns in cash. Remember our risk/return charts from before? Cash is not the only investment in which one can invest. An investor may choose from the universe of investment options on planet earth: U.S. stocks, U.S. bonds, developed market stocks, developed market bonds, emerging market stocks, emerging market bonds, commodities, gold, and real estate. Further, there are a myriad of alternative investments in which one can invest. This leads us to question investment returns relative to borrowing costs.

What about Investment Returns?

Starting again with the big picture, if your returns are higher than your after-tax cost of debt, the L.I.F.E. path will always be better. If you capture a larger spread, the power of the L.I.F.E. path is mind-blowing. Here is the ironic twist: If you think that investment returns will be low relative to your cost of debt over the next 30 to 70 years, then you need a bigger base of assets working for you as early as possible in life, not a smaller base of assets, in order to hit your long-term retirement goals. In a lower spread environment, the L.I.F.E. path is still better!

Let's say that you think returns will average 1 percent over your after-tax cost of debt. You still capture a spread and have more liquidity and flexibility as a result of the strategy. The L.I.F.E. glide path added value in higher returns and more flexibility.

If it is true that you think that no investments or diversified portfolios return a higher rate of return than your after-tax cost of debt, what should you do? Let's do the math on this. Let's assume that Brandon and Teresa think that their borrowing costs for the next 40 years will be 2.5 percent and their investment returns will be 2.5 percent. To try to keep things apples to apples, I will assume that they cover the interest expense from cash flow and that principal payments come from “savings.” This will let them pay off their mortgage in the same 21.6 years. If they keep saving $9,000 for the next 18.4 years and have a return of 2.5 percent, Brandon and Teresa will retire with $207,000. Without Social Security, they are out of money in about five years. Paying down debt or investing, they are in bad shape for their retirement goals.

The bottom line is that if you think your returns from all assets on planet Earth will average less than your after-tax cost of debt, you are stuck. You will either need a very short retirement (working longer) or to save at a very high rate, or both.

If this is the case, it is difficult to solve the gap through savings. For an extreme example, consider if Brandon and Teresa are scared and hate debt, hate risk, and hate investing. They feel their investment returns will be less than 2.5 percent. Their mortgage is at 2.5 percent. Therefore, they decide to increase their savings, pay down debt, and then build up assets. If they increase their savings to 30 percent of their income, $18,000 per year, they would pay off their house in 17.3 years. Their portfolio at 2.5 percent would grow to about $540,000—double the savings rate of the L.I.F.E. glide path, five more years of working, and fewer assets! And while this is impressive, it likely is not enough for them to sustain for the next 30 years.

To be more extreme, if an individual has a return of zero and works for 30 years and then wants to retire for 30 years with the same income, she would need to save 100 percent of her income during her working years, which, of course, is not possible.

In fact, while it is true that she might have Social Security and be able to live on less, it is also true that due to inflation, her money might not go as far. If her return is truly zero, then even saving one year of income won't make it. For example, my mom was a teacher. In her first year of working, she made about $7,500 in the 1970s. If she saved all of that income for the whole year and had a return of zero, then it would potentially cover less than a month of her living expenses today.

Remember the diversified portfolio from Chapter 5? Over a 10-year period of time, a diversified approach outperformed inflation plus 4 percent in 92 percent of every rolling 10-year period of time. The diversified process also outperformed inflation + 2 percent in 97 percent of every rolling 10-year period of time. The diversified process outperformed inflation + 6 percent in 54 percent of every rolling 10-year period of time.

This is not a recommendation to follow the diversified process or any statement on what it will deliver in the future. What we can see is that if your borrowing costs are close to inflation, and your portfolio is diversified across many asset classes, there may be a chance that on average, and over a long period of time, you can capture a spread, and capturing even a modest spread can be valuable.

I do not know future returns, but there are two possibilities: Future returns will be lower than the after-tax cost of debt or they will be higher. All of the strategies we are looking at have risks. Our job is to assess all of the possible strategies and choose the course which maximizes the odds of your success while minimizing the excess risk taken.

The combined implications of this are vast. If you truly believe that returns will be lower than your after-tax cost of debt, then you believe in a short retirement and/or a high savings rate. For this group, I would suggest that you consider a middle ground. Move your savings rate to 30 percent and embrace the L.I.F.E. path with 15 percent of your savings and the pay-down-debt path with the other 15 percent. If you are in this camp, then you are already signed up, knowing that your likely case is that you work for a long, long time, which is a clear possibility under your current assumptions. I think the alternative path is better, as you have little to lose relative to your alternatives and you have an added possibility that you could be on track for retirement.

What about the Impact of Savings Rate?

If Brandon and Teresa saved at a rate of 20 percent, $12,000 per year, then holding the rate of return constant and inflation plus 4 percent would result in a portfolio of $914,000!

The L.I.F.E. path works exceptionally well with a 20-percent savings rate. It's about right at 15 percent. If you save less than 15 percent, then the unfortunate news is that there is little mathematical chance of you being on track, unless you believe in large returns or have an exceptionally long time horizon (or never intend to retire). If you are saving less than 15 percent and have a time horizon less than 35 years, then I would strongly encourage you to consider the potential benefits and risks of embracing an optimal debt strategy. If you believe in large returns, then embracing debt will complement your strategy. If you believe in low returns and have a low savings rate, you have to have debt to make it, or you are doubly stuck.

If you save more than 20 percent, you have flexibility. The greater your savings rate, the more you can afford to consider paying down debt early in life. The lower your savings rate, the less of an ability you have to consider paying down debt early in life. At the same time, it is my position that until you build up enough assets to be able to pay off your house, you should not pay off your house. The risk is too great and you lose liquidity.

There are three interconnected levers: your savings rate, your existing assets, and time until you retire. If you have a long time, a high savings rate, and a good base of assets, then you should be on track for retirement and can choose to pay down debt. If you have a short time, a low base of assets, and a low savings rate, then you need as many assets working for you as you can and will want to direct savings toward investing rather than paying down debt, assuming that you can get your cost of borrowing close to inflation or inflation + 2 percent.

What about the Tax Factor?

This concept gets a sliver complicated, but a neat byproduct of this strategy is that you are consistently adding funds to your taxable and tax-deferred accounts, throughout your lifetime. Therefore, there should be little need to sell from your portfolio.

Let's say that I have a diversified portfolio of 10 exchange-traded funds (ETFs) and I start out with a weighting of 10 percent in each one. Half of them go up 5 percent and half of them go down 5 percent. Half would now have a weighting of 10.05 and the other half at 9.95. When you add funds, you will be buying up the areas that are underweighted and not adding to the areas that are overweighted. As a result, you can actually rebalance your portfolio through contributions rather than by selling. At a minimum, any sales should take place as long-term capital gains because the investment should have been held for at least a year.

Also, by maintaining a mortgage throughout your life, you maintain the tax benefits associated with that mortgage. This can not only create a tax-free retirement but also significantly reduce taxes during working years.¹⁴

What if the Tax Deductibility of Mortgages Goes Away?

The tax deductibility of mortgages may go away. This is constantly a topic of conversation in Congress. Who knows what will happen with Congress, but here is a framework to address it:

An elimination or phase-out in the tax deductibility of mortgages increases the cost of the mortgage. You always want to look at your after-tax cost of debt and compare it to your investment options. If you think you can capture a spread, over a long period of time, then there is value to the debt. If the deduction is eliminated, your spread may fall, but even a small spread is powerful over time, and you have the added benefit of liquidity, which gives more flexibility.