Let’s talk about fear
Let’s talk about fear for a moment.
The biggest source of society’s aversion to debt is fear. And all of us saw how vulnerable the market can be when it collapsed out from under us in 2008. Even millionaires have in the pits of their stomachs a worry that their fortune will suddenly turn on them.
A huge part of investing is mitigating the “what ifs,” because they’ll eat you alive if you let them.
Beginner investors—heck, almost everyone—is paralyzed by the thought of interest. It feels Sisyphean. You roll the boulder of interest back up the hill each month, and every time you fail, the boulder gets bigger until it crushes you.
It’s true, when you purchase an asset with debt, your cash flow decreases because you have to use part of it to service the debt, and because of interest, the cost of the asset goes up. In brief, the asset costs more and you have less money to pay it off with.
But cool your jets. Interest is nothing more than another factor to take into account. A proper strategy weighs the cash the asset will bring in against the total cost of that asset. Such strategy takes the long view, and while a longer lifespan of a debt means more time for problems to occur, a proper strategy minimizes the risk for disruption. Like anything else, debt has to be taken on responsibly.
Apple took on $6.5 billion in debt in 2015, to complete its stock-repurchasing plan (a paper asset) that would make the company more valuable for investors. Paying cash would have meant bringing their cash assets from overseas, which carried a tax penalty near 35 percent. Instead, Apple found the potential asset more valuable than the debt, and the debt less expensive than the loss of overseas cash assets. And they were right. Their debt, which ranged from 1.5% to 3.45% interest, saw Apple stock increase 30% to 40% each year. Microsoft made a very similar move in 2016 to avoid paying taxes on repatriated money during their acquisition of LinkedIn.
In 2014, Guardian, an insurance company, issued $450 million in 50-year surplus notes at a 4.875% interest rate. The company’s annual report described the issuance as a low-cost way to fund long-term business objectives, saying the notes are, “… a reflection of how Guardian is determined to find the best opportunities in any economic climate.” If the company achieves a return of at least 4.9% or more on the $450 million over the next 50 years, it will come out on top. 4.9% over 50 years isn’t a stretch.
Irresponsibility is the real problem, not debt.
Any damning conversation about debt should be recast into a conversation about responsibility. Debt spirals out of control as a result of poor, ill-informed, or fearful decision-making.
Furthermore, fear often drives the average consumer to overfund their debt. They pay off more than is required, or they structure payments in a way that amortizes – finance speak for “extinguish” – the debt quickly. At a first glance, the logic makes sense. The less time it takes to pay off the debt, the less time is allowed for something to go wrong, and the quicker money formerly used to make debt payments will be available for other use.
But over-servicing your debt can bite you in the butt. When a borrower uses their cash assets to overpay their debt, they diminish their access to cash in the event that an opportunity – or an actual emergency – presents itself.
For example, let’s say two men each purchase a home for the same price, at the same 30-year fixed rate. The first man wants to pay off the debt as fast as he can, so he continues to pay more than the required payment, while the second man only pays the interest and puts his excess funds in a savings account. Five years down the road, Man 1 has significant equity in his house, while Man 2 has no equity in his house. Both men encounter a financial emergency and find themselves unable to pay their monthly mortgage payment.
Which of the two houses will the bank most likely seek to repossess? The one with equity or the one without equity? The bank will seek the home with the added equity.
Now, which of the two men will likely have more financial leverage to address the emergency? The man who has spent all his extra money on aggressive debt service, or the man who has saved his extra money and now has cash to pay for the mortgage? I don’t think I have to tell you.
Aggressive debt service – when devoid of strategy — puts consumers and investors at risk of the very thing they fear.
So let’s not stigmatize the wrong thing. Aside from purchasing something straight out of your cash accounts, purchasing it with borrowed money is the only way. At Addicus, we can help put debt to use with prudence to enhance that ever-important PFE. That is to say, enhance you.