5 Myths About Debt

Oct
28

Debt can be a balance-sheet weapon, but many don’t see it that way, because fear gets in the way. And that’s a shame. Because here’s the thing: On its face, being debt free seems like the commendable thing to strive for, the coveted thing and the thing that most of society celebrates.

But we’d like to suggest that wiping debt from your balance sheet is overrated. We’ll unpack the reasons why by using five myths to substantiate the premise. We’ll talk about what it means to pair debt with assets, and we’ll teach you how to choose the types of debt that pair well.

Myth # 1

You can’t be financially responsible if you’re strapped with debt. 

This is the jumping off point for most who labor to pay off their debts, even when that means overpaying on what’s owed. Because it makes sense, right? How can you be disciplined in your financial management if you’re buying what you can’t readily pay for?

But this way of thinking doesn’t factor in a thoughtful strategy — the effective structuring of your Family Wealth Enterprise (FWE). A sound structure uses everything from your tax obligation and debt to assets, revenues and other financial vehicles to create circumstances that dictate how cash flows to and from entities within your enterprise. Each piece, if paired and structured thoughtfully, has a critical role in the strategic success of your enterprise.

When it comes to debt, it’s best understood in stages. If you ask a young child to name the lowest number, the child will tell you it’s zero. And the child is right. At least until negative numbers become part of their educational curriculum. But negative numbers aren’t introduced initially because educators understand that children of a certain age aren’t developmentally ready to grasp the abstract nature of negative numbers.

For debt, the first learning stage is financial responsibility. In this stage, debt should be avoided. But once financial responsibility is mastered, that mastery will ultimately lead to an advanced stage of an investor’s maturity where debt evolves from something to be avoided into a tool that can be leveraged.

Still, this is only true in due time, as an individual progresses through life and business opportunities to acquire a level of wealth where assets can benefit from a properly placed debt pairing for a greater return on equity.

Myth # 2

Lifestyle assets are useful investments that can be used as debt leverage.

No way. Lifestyle assets are not investments. In the book “Rich Dad Poor Dad,” writer Robert Kiyosaki rightly refers to lifestyle assets — boats, cars, RVs — as fool’s gold. These assets won’t put money in an investor’s pocket. Not only does this hold true for items like boats and cars, but it’s also true for primary and secondary vacation homes.

While a house may accumulate equity over time, the property will likely remain a personal asset that is never monetized at the level of most investments. Also, generally these homes have a lifestyle associated with them that further adds to the carrying cost. For these reasons, primary residences and second homes are considered a lifestyle asset, not an investment. 

With that said, should you choose to own these assets, debt placed against them to conserve other cash or create liquidity against reinvestment may choose to be a useful tool.  Further, these assets generally should not be regarded as “sacred cows,” desiring to have these paid for while others are encumbered by leverage.  The reason for this is that debt is debt, and whether the asset is pledge directly or not, chances are it is still on the hook due to debt guaranty arrangements (some states such as Texas, Florida and others provide additional asset protection for homestead, so advice could change state to state of primary residence).

It’s also worth noting that other assets — real estate, raw land, business interests and paper assets — have similar, associated costs not unlike a second home or lifestyle assets.

The difference is that these assets are generally owned with the primary purpose being:

1.    Cash flow

2.    Appreciation of the underlying asset 

Myth # 3

Debt has nothing in common with a bottle of fine wine.

Wait. What? (OK, fair enough, this myth is sort of made up.) But it works. To fully realize everything a glass of wine has to offer, it must find its ideal pairing. The same holds true for financial leverage, otherwise known as debt to most.

Remember the concept of creating structure and circumstances for your Family Wealth Enterprise? Within this strategy, pairings are critical. 

“Leverage is the type of borrowing used to amplify returns and should be viewed opportunistically,” writes Addicus Chief Enterprise Architect and founder Andrew Adams in “Stop Blaming the Debt,” a whitepaper published by Addicus. “But it should be managed carefully by strategy — like a loaded gun.”

And, in keeping with our theme that debt is a valuable balance-sheet weapon, then it’s timely to consider recasting what debt means to wealth. When the borrower’s intention is to create additional wealth, the term “leverage” should replace the more negatively associated “debt.” 

How do investors create additional wealth with debt, you might ask?  Think about this: If you own a piece of real estate that is generating cash flow of 8% of the asset value and the debt rate is 3.5%, then the investor is earning a 4.5% spread on debt (OPM – Other People’s Money).  Based upon the leverage ratio 2:1, 3:1 or 4:1, this can leverage the return of the investment.  For example, let’s say leverage is 4:1 (80% Loan to Value  or LTV), the asset earns 8% and the debt to return spread is 4.5%. In this example, the investor’s equity (on a linear basis, not actual internal rate of return or IRR) is earning effectively 26%.  

Myth # 4

The most prevalent reason for society’s aversion to debt is couched in a mistrust of our banking institutions.

While mistrust probably exists to some degree, that’s not the prevailing emotion we’ve encountered when addressing debt with our clients. Instead, it’s fear.

Just as greed or lust crowd judgement, so does fear. Fear is often the emotion behind many poorly conceived strategies in wealth management. And it’s not just debt that’s affected. Fear is a primary culprit when taxpayers fail to take bold positions on their tax returns, even as the result could be substantial tax savings.

With debt, consumers are most commonly afraid of their inability to repay a debt if something hampers their cash flow. Deep in the belly of every millionaire is a cash-flow concern beginning with the words, ‘What if,’” says Adams in “Stop Blaming the Debt.”

And you know what? The “what if” did happen. Even more, it wasn’t generations ago.

“These fears became a reality for many Americans in 2008 with the financial crisis and market collapse,” says Adams. “Debts in the form of mortgages and commercial loans turned into bankruptcies in too many cases. In fact, some very successful investors and real estate owners/developers lost everything because of debt.  Just keep in mind, their leverage was missing two key ingredients: strategy and a contingency plan. 

Because of this fear, the average consumer overfunds his or her debts, paying off more than is required or structuring payments in a way that amortizes the debt quickly with the goal of getting rid of the debt as soon as possible. When fear hinders decision-making, the primary goal becomes the avoidance of any potential payment speed bumps. The prevailing logic is to get rid of debt as quickly as possible, which sometimes leads to doubling or even quadrupling the normal debt service — creating even more risk and leading to the very cash-flow problem the investor was fearful of in the beginning.                                                        

When borrowers use their cash assets to overpay their debt, they have diminished access to cash in the event of financial emergency or lucrative opportunity.

Myth # 5

Paying off my debt saves me money and adds to my wealth.

The rate of return on the equity in your assets is 0%, and with inflation, it is actually negative.  I know, this sounds ludicrous, right?   Think about it for a minute though; let’s say you own a commercial building worth $5 million.  In one scenario, you owe $5 million, meaning you have no equity in the property. In the other scenario, the asset is paid for.  Comparing these two scenarios, is there any difference in the appreciation of the asset on a year-over-year basis?  The answer? There is no difference whatsoever. 

The fact is, having a ton of equity in your assets does not necessarily improve your performance overall or save you money.  Even just taking the cash that would have been used to pay down debt, and simply tying the cost of the borrowing with a low-risk investment would be better because it provides a ton of flexibility, safety and confidence.  At the end of the day, it all comes down to having a plan, being prudent and making wise investment decisions.  How to pay for assets is just a part of the equation, and there’s nothing emotional about debt. 

What’s Next?

By dispelling myths — some common, some not so common — we wanted to challenge how you view debt, and how society has framed debt as something that’s negative. In reality, debt is truly a weapon. It’s a tool that can be leveraged in strategic ways to become a legit difference-maker for your Family Wealth Enterprise.

If these five myths have been consumed like breadcrumbs, and you feel you’ve only gotten a small taste of what debt can mean to a larger, structured strategy, dig deeper by downloading our whitepaper, “Stop Blaming the Debt.” The paper can provide greater substance as you consider how to use debt as leverage.   

                                                   

See More Posts