The Value of Debt in Building Wealth. Thomas J. Anderson

The Value of Debt in Building Wealth

$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.

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1

Author's note: The information in this chapter is to be considered in a holistic way as a part of the book and not to be considered on a stand-alone basis. This includes, but is not limited to, the discussion of the risks of each of these ideas as well as all of the disclaimers throughout the book. The material is presented with a goal of encouraging thoughtful conversation and rigorous debate o

1

2

See the concepts of weighted average cost of capital and the Modigliani-Miller Theorem: F. Modigliani and M. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review 48, no. 3 (1958); F. Modigliani and M. Miller, “Corporate Income Taxes and the Cost of Capital: A Correction,” American Economic Review 53, no. 3 (1963).

3

This is not an impossibility. For example, if housing is a great investment that maintains its value after depreciation, then investors should be willing to buy houses and rent them at a low rate to consumers, capturing not only the rental income, but also the appreciation of the asset as their total return. Rental rates could in fact be lower than purchasing rates. This in fact happens in many markets today, within and outside of housing.

4

Note that many consumers' desire to own is not limited to assets that we perceive to be likely to go up in value over time. Consumers also want to own items that are more likely to go down in value such as cars, boats, clothing, and intangible assets such as education (which theoretically leads to higher productivity and wages, a positive trade-off, or better future opportunity).

5

Results based on survey conducted by Supernova Companies in December 2015. The survey featured 394 respondents who met the following criteria: age 21–60, minimum of college degree, and annual income of at least $50,000. Full results are available here: https://www.surveymonkey.com/results/SM-KCDY3XGJ/.

6

Nari Rhee, “The Retirement Crisis: Is it Worse than We Think?” National Institute on Retirement Security (June 2013). http://www.nirsonline.org/storage/nirs/documents/Retirement%20Savings%2 °Crisis/retirementsavingscrisis_final.pdf.

7

Angela Johnson, “76 % of Americans are living paycheck-to-paycheck.” CNN Money (June 24, 2013). http://money.cnn.com/2013/06/24/pf/emergency-savings/.

8

Ibid.

9

Rhee, “The Retirement Crisis.”

10

This is a central theme of Thomas J. Anderson, The Value of Debt (Hoboken, NJ: John Wiley & Sons, 2013). In particular, Chapter 3 goes into extensive detail on corporate debt ratios. For those who would like detail, see endnote 3 from Chapter 3 of The Value of Debt.

11

Lucinda Shen, “Now There Are Only Two U.S. Companies With the Highest Credit Rating,” Fortune (April 26, 2016), http://fortune.com/2016/04/26/exxonmobil-sp-downgrade-aaa/.

12

The case studies presented are for educational and illustrative purposes only and cannot guarantee that the reader will achieve similar results. Your results may vary significantly and factors such as the market, personal effort, and many others will cause results to vary. All of the case studies throughout the book are hypothetical and not intended to demonstrate the performance of any specific security, product, or investment strategy. Opinions formulated by the author are intended to stimulate discussion.

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