Conventional wisdom says that if you want to be in good financial standing, you need to be debt free.
However, is all debt bad? If you take into consideration tax breaks and liquidity, can debt be considered financially sound?
Tom Anderson, CEO of Supernova Companies and author of The Value of Debt: How to Manage Both Sides of a Balance Sheet to Maximize Wealth, shares his financial philosophy which revolves around balance. Tom argues that debt may have long-term financial gain because debt gives someone liquidity and flexibility. He also breaks down debt into three groups and warns about oppressive debt. Should you pay your mortgage off? Listen to what Tom has to say.
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Learn more about Tom Anderson by reading his book The Value of Debt: How to Manage Both Sides of a Balance Sheet to Maximize Wealth or follow him on Twitter.
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Interview With Tom Anderson
Is having debt ever a good thing? Should you be afraid of it, or should you rather embrace it? Tom Anderson, Founder and CEO of Supernova Companies, explains.
Douglas Goldstein: I am very excited to be talking with Tom Anderson, who is the founder and CEO of Supernova Companies. Other than having a really cool name, they also make technology for making lending more efficient.
We talk a lot about debt and borrowing money, and a lot of times, quite frankly, I am pretty down on it. But Tom has actually written a book about the value of debt. Coincidentally, he called it The Value of Debt, and made it to the New York Times bestselling list.
Tom, why is debt so valuable when so many people like me tell people to be so afraid of it?
Why Is Debt so Valuable?
Tom Anderson: Thanks, Doug, for having me on the show. I really appreciate it. It’s great to be here. It isn’t so much that debt in itself is what I am about. I am about liquidity, flexibility, and people having the highest probability of success, and of accomplishing their financial goals. In many cases, that can include debt because it’s a tool we use throughout our life.
Douglas Goldstein: Let’s break that down because I think that covers everything. Why does debt give you more liquidity, because it seems for many people when you owe money, you’re always afraid that, “Oh my gosh, I don’t even have enough money to pay the bills”?
Tom Anderson: Yes. Imagine a simple scenario; someone gets a large winning or an inheritance of $100,000. They step down and pay that on their mortgage because that’s what conventional wisdom says you should do.
The next day, they lose their job. It turns out you can’t get that $100,000 back. It’s a one-way liquidity trap. What happens is if they had some of that money in the bank, rather than just rushing to get rid of debt for debt’s sake, they could survive a storm or crisis. The most important thing, to me, is that people can make it through crises.
Douglas Goldstein: Let’s use some numbers. You brought up the $100,000 number and that’s a good figure to work with. How much liquidity does a person really need? I talk to people about an emergency fund – keep three to six months’ worth of spending in an emergency fund. Depending on your job, maybe 12 months.
Okay, so now you get an inheritance of $100,000. Why not pay off the mortgage?
Tom Anderson: It depends on where you are, relative to your net worth and your long-term goals. The books put a lot more math around this. But conceptually, if you have a net worth more than 30 times your annual income, you don’t need to have debt.
If you want $100,000 a year in income, and you have a net worth of more than $3 million dollars, there’s a good chance that you have plenty of money and you don’t need to have debt. If you have a three to six months’ cash reserve, you’re just fine.
Very few of us find ourselves in that circumstance. What we actually have is a debt to our future self; we have unfunded obligation, our retirement. What we need to be doing is balancing wanting to get rid of debt today, and making sure that we’re on track for the financial future that we want to have.
Douglas Goldstein: Is liquidity important for other reasons?
Why Is Liquidity Important?
Tom Anderson: Liquidity is important for a whole lot of reasons. It’s amazing... I don’t understand why our society is so check to check. In fact after 2008 - it’s interesting - people said, “Debt is the evil that caused the crisis,” and then rushed to pay down their debt.
But look at what companies have done. They’ve actually expanded the amount of debt that they have and the amount of cash. They’ve built up war chests of liquidity to be able to avoid virtually any storm that might come their way again.
It’s interesting to contrast the difference between how people and companies have responded to that crisis.
Douglas Goldstein: Don’t the companies have a lot of debts simply because since the crisis, debt has been unbelievably cheap? In other words,– we can get into the politics of it – but the Federal Reserve lowered interest rates in order to make it easy for companies to borrow and hopefully rebuild the economy a little bit.
Who’s not going to borrow money when as a company you can borrow it at, let’s say, 1%?
Tom Anderson: I think you’re right. Companies have debt because they’ve valued the liquidity, the flexibility, the tax benefits, and the possibility that they could capture spread. Or that they could earn an average rate of return higher than their after-tax cost of that debt.
Those are all principles that people could learn from as well. They have CFOs that they hire to help design that balance sheet. We can learn from those principles; there’s a lot of Nobel prizes on this topic. All I do is take those and apply them to the individual.
Liquidity and Flexibility: What’s the Difference?
Douglas Goldstein: Tom Anderson has been talking to us about why debt is good, and also why debt is a tool for helping to increase liquidity and flexibility, and ultimately to perhaps increase the chance of success.
I just want to get down to some semantics because you used both words and I want to know if they mean the same thing to you. You said both “liquidity” and “flexibility.” Are these different?
Tom Anderson: They are different. Liquidity - what I am trying to make sure is that I have enough oil in the engine to be able to take care of any crisis that comes my way.
In many cases it’s not just the crisis that I might face, but maybe I’ll find myself in a position where I am taking care of my children and I am helping out my parents. For many people, they’re the liquidity source in a time of emergency for the loved ones around them. I always want people on more liquidity.
Flexibility is simply what things like Apple are doing today. Apple has billions of dollars of cash and they have billions of dollars of debt. If they don’t like that strategy, or feel value in it at any point in time, they can pay off their debts.
When you embrace the ideas - and in my books it’s not about debt for debt’s sake – if you do it in the right way, you can always pay off your debt any time that you want to. You’re choosing to have it, thinking and acting like a company.
Explaining “Oppressive Working and Enriching Debt”
Douglas Goldstein: It feels a little different when you talk about a company, because one of the things you mentioned a moment ago was that companies can borrow money. Hopefully, they can then actually make more money on that money than the amount that it’s actually costing them to borrow it.
Meaning if Apple issues a bond, and is borrowing money (let’s say 2% or 3%), they believe that on the $1 billion that they borrow, they could make more than 2 or 3%.
But for normal people, a) because we’re not Apple, we don’t get such good terms on a loan, and regular folks might be paying 3%, 4%, 5%, 6% or more. Is there really a way for them to then make so much more money, because if they were just to pay off the debt, that’s like making 6% per year, no?
Tom Anderson: That’s a great question. I grouped that into categories. What I call “oppressive working and enriching debt.” Oppressive debt’s going to be any debt that has a rate north of 10%.
Let’s say that you have credit card debt at 20%. You have to pay that off right away. That’s bad debt – it will never be good for you, and that’s not what my ideas are about. All high interest rate debt automatically needs to be eliminated.
Working debt could be, for example, like a student loan that’s at a low rate, and it may or may not have tax benefits. A mortgage - in the United States at least - potentially has not only a low rate, but also some significant tax advantages that get really close to those corporate borrowing rates.
Enriching debt is when you literally have the money in the bank that you could choose to pay off at any point in time. Yet you choose not to. You’re choosing to maybe capture the spread; so I am borrowing at 3%, and I am earning 5%.
Forget about the days of 10% or 12%. A 2% spread over time, you’d be surprised how powerful that is when you compound that out.
Douglas Goldstein: On the student loan debt, that’s a good example because lots of people really talk about it quite a bit. It seems that the rates students are paying are actually somewhat high. In fact there’s both government and private debt, and kids look like they’re paying 4%, 5%, 6%, 7%.
You’re marking the oppressive debt at 10% or above. Again, I just don’t see how someone can feel pretty confident that after tax, he could make more than 5% or 6% confidently, that it would be worth having that level of debt, or that cost of debt.
Tom Anderson: You’re making very valid points, and I don’t disagree with them. I’d fine-tune them as follows; so many people are in such a rush to get rid of their student debt that they’re doing it at their own peril of liquidity.
Many young people end up wanting to move. They face a job change, or life challenges. Good things love bad things, and they simply need money in the bank.
People, a lot of times, sign up for life insurance in case something bad happens to them – the burden goes onto loved ones when they die. Nothing insures you like money in the bank. Of course I want the rates to be lower, but people need to emphasize that liquidity.
Once you have some liquidity, you’re making a strategic choice, and with that strategic choice, I agree with you. If the student debt is at a lower rate, and it’s government-subsidized and it has tax benefits, then maybe you want to keep it. If it’s at a higher rate, maybe you want to take steps to eliminate that.
In my third book, I actually provide very specific and actionable steps on what should be the deciding factors of, “Do I keep this debt, or eliminate it, and where do I build up my long-term resources?”
Douglas Goldstein: Alright. Tom, there’s actually a lot to talk about. In fact I know that in your books you really cover a number of different issues at different stages in life. I actually have the feeling, from this conversation, you and I agree on using debt, and the concept of liquidity. In fact I think that we really do agree on how to do it, but you just have to do it in an intelligent fashion.
The same way that a company has a CFO who spends all of his time thinking about these issues, instead of people just randomly borrowing money and not thinking about it, if they do it in a smart way, they might actually be well-served to use debt.
How to Follow Tom Anderson
But unfortunately we’re not going to be able to get into it much more. In the last few seconds, Tom, can you tell us how people can follow you and follow your work?
As you said, debt is like a red wine or chocolate. A little bit of it the right way could potentially be good. Too much of it’s bad, so you’ve got to have a thoughtful strategy as you move forward.
Douglas Goldstein: That’s a great conclusion. Tom Anderson, thanks so much for taking the time.
Tom Anderson: Thank you.