Carrying Debt: The Roller Coaster Effect

Not long ago, I shared a post about paying off your mortgage versus investing. As I stated in that post, I was dealing with the mathematical data in a vacuum. Most of the time, when math is done in a vacuum, it does not account for the “what ifs” of life. Each and every one of us rides a roller coaster of emotion from one day to the next. In that blog post, I simply provided the scenarios based on average statistics. Mathematically, it does not make sense to pay a mortgage off! However, that doesn’t mean it’s the wrong choice to make. Let’s take a ride on the debt roller coaster to understand.

I received tons of feedback concerning the post. Why did I use age 50 in the previous blog post? Why would you ever pay the mortgage off? What if the stock market performs lower? Etc. Each and every one of the questions is valid. So I decided it was time to look on the flip-side, just to give you a contrarian thought to this whole process of continuing to carry the debt on your home.

There is almost a Jekyll and Hyde mentality when you start looking at it from the emotional side. Taking on debt involves risks; risk to your lifestyle. Popular financial talk show host Dave Ramsey is excellent at driving home HIS viewpoint that debt is inherently bad. Mention debt to most and you’ll get a negative connotation. However, for me, it’s hard to completely justify that mentality.

Is Debt Good or Bad?

Debt is an object nothing more. Here is an example. If we are bucking debt as a whole, then theoretically bonds are bad. Bonds are used by corporations or governments to raise capital by borrowing money from investors at either variable or fixed interest rates. Knowing the advantages to this type of debt though, it makes it nearly impossible for me to classify all debt as evil. So, I just can’t classify debt as good or bad, right or wrong.

However, using debt to build wealth can be adversarial. In the first post, I took the math and flipped the idea of paying your house off on its head. I showed you that in a perfect scenario, keeping the debt on your home and in turn investing the extra cash flow in the stock market could leave you quite a bit richer in the end.

Nevertheless, what that math neglected is, reality. The reality that life happens. People lose their jobs. Loved ones end up diagnosed with cancer. Spouses pass away early. And all the other unplanned and tragic experiences that can and will overwhelm us in life. The truth is, life just isn’t as plain and straightforward as a mathematical equation.

When it comes to debt, I HATE it—with a passion. The only debt that I owe on is my home. My current debt to asset ratio on the home is around 50%. In other words, if I sold my house for a $100,000, I would only owe $50,000 of that the mortgage company. That’s where my minimum threshold comfort level is for debt. The reason for that is if the economy were to collapse or tragedy struck my family, and I needed to, I could sell my house, walk away and if nothing else break even. Every other asset, which I own, is paid for in full.

So, I personally hate debt. Most of the time it is counterproductive to wealth building. Now having said that, I do use credit cards. However, they are paid in full every month. Just this year alone, I already received $700 in free gift cards from points I received using my cards, and I have not paid a dime in interest. I don’t mind using debt, but I hate it, I hate debt. Now, I think I have cleared the air on that. Think of it as my disclaimer for everything else I’m going to say in this post.

The Debt Roller Coaster

Now, let’s talk about lifestyle risks. There are so many things in life that could happen in which having debt would be a major problem. I’ll start with one that, as a business owner, I personally experienced, litigation. I went through a tumultuous legal battle for five years with a former business partner. Now, had I carried a significant amount of outstanding debt, those five years could have left me high and dry. That lawsuit would have put me into bankruptcy if it weren’t for the liquidity of my assets at that time. But because I’ve never been one to carry a significant amount of debt, I was able to weather the storm of the lawsuit, which put a major strain on my income during that time.

Another risk that carrying debt could bring your lifestyle crashing down is an economic collapse.  Many people have already dealt with the financial crisis of 2008 and seen firsthand the devastation that carrying debt can do. I personally know real estate investors that borrowed to build wealth, yet ended up filing bankruptcy. After the housing market bottomed out, they did not have enough cash flow from their jobs to keep from sinking in the crisis.

Our health is just as important as our wealth, if not more. If my health dissipated and I could not physically do my job anymore, then my disability insurance would more than cover my family’s lifestyle. That would not be the case if I carried a significant amount of debt—whether it was mortgage debt, consumer debt, car debt, credit card debt or whatever. In that scenario, then my disability policy absolutely could not meet my family’s needs, and we would need to significantly change our lifestyle. So, we need to identify health as a lifestyle risk of carrying large amounts of debt.

All of us could have a health issue in our family which could change things. If something happened to my wife today, it would change the entire dynamics of my family. If one of my kids’ health declined, it would change my family. There are lifestyle risks that can prevent you from achieving something and being tackled by debt could cause major financial harm.

Another risk to understand is uncertain debt. The debt itself is a risk. For example, I have clients that sought certain types of unsecured or uncollateralized debts. All the sudden the bank called the terms, and they were scrambling to refinance these debts.

I personally experienced something along these lines. My wife and I have a rental property that we originally financed in 2003 using a THDA law—which is a Tennessee development loan. In the middle of the life cycle of the debt on this property, the rules that I agreed upon during the purchase came back to bite me. I overlooked the terms that said that this property was to be a primary residence only.

So our lifestyle changed and our family grew, we went on to buy another home and began renting our first home. As soon as the lending company found out we no longer lived there, they called the note. So, here I am trying to quickly refinance a loan on an asset in which I had turned into an income producing asset. However, had my debt to income ratio been out of whack, we could have found ourselves in quite a mess. Fortunately, since our debt was almost non-existent, we were able to quickly secure a loan. So, debt risk itself can cause problems.

We all face political risks that can cause problems. Right now we are seeing relatively low tax rates, but at any given time, politics can change. Reform in the tax code could take someone that is currently paying 10-15% to double or possibly even triple their tax rate. We are at Washington’s disposal. A change in tax rates could leave us with less disposable income to carry debt. That’s where we run into a taxation called phantom income. Basically, we pay our revenue to the bank but yet we’re still taxed on it, and that creates what’s called a vortex effect.

I’ve got a client right now dealing with a debt vortex. He tried to pay off debt and ended up owing the government. Now, they are charging him 14.7% interest on back taxes. Additionally, in order for him to even pay the IRS, he is forced to produce more income, which in turn causes his current tax rate to go up ultimately causing him to pay more in taxes. It’s a never-ending cycle that he is going to have to borrow his way out—all because of a regulation change. So, I have actually seen where this particular transaction causes some major debt issues.

I know business owners that want to accelerate the growth of their companies, but they are so burdened by debt, that they just cannot make the tactical shifts needed to do so, which ultimately, harms their livelihood. And it is all because of debt.

The emotional stress of debt can often be too much to bear. Clients tell me stories of the mental and emotional strain debt has taken on them. Others open up about the toll debt took on marriages—even to the point of divorce. When their marriages were dissolved, the only way they got out was through bankruptcy. It’s clear to me that the emotional effect of debt on an individual could be catastrophic. There really isn’t a way to quantify the devastations of debt’s stronghold. I’m not even sure there are words to convey the turmoil I’ve seen others go through because of debt.

While I can mathematically prove that debt can and will cause one to build additional net worth, I can also experientially prove, both from a personal standpoint and from advising clients, that debt is your enemy, causing more harm than good. So where does that leave us?

Well, I believe that personal debt should be eradicated as rapidly as possible. So for those Dave Ramsey followers, do the baby steps. Work the system. I strongly agree with it. Build an emergency fund; I support that. Invest at least 15% of your income.[That’s 15% of your gross income business owners! What I mean by gross income as we all know that we use business things for personal gain like vehicles, like travel, etc., all of those need to be added back to get your gross!]

I wholeheartedly support reducing debt as fast as possible. After all, this is the life I am living. I’m investing in my business—which is driving net worth. Then I’m investing 15% of my personal income into my long-term retirement accounts. Additionally, I’m making extra payments on my debt on my a systematic basis. Why? Because I hate debt. I do not think its good on a personal level. Now, from a business standpoint, I can see how companies use debt for gains. However, even then, I personally believe debt on a business can be detrimental.

What Should You Do?

So if you find yourself in heavy debt, having a hard time even investing the 15%, now is the time to get angry. Start repositioning and eliminating the liabilities out of your net worth. You MUST start reducing debt!

Debt is not inherently evil; it has its place. Many times, people can use debt for good, mathematically debt makes sense at times. Despite that, debt can cause catastrophic ails to your financial life. 100% of the people who lose their homes or file bankruptcy do so because of debt issues, no other reason than they owe a liability to somebody else. Debt is not the devil. It should be utilized in certain circumstances and minimized as much as possible because of the potential adverse effects that it could have on your lifestyle.

Now, we can mitigate some of those risks. We use insurance to lessen risks to our autos, homes, health, business, etc. Legal contracts to diminish risks. Savings and investment accounts put us in cash positions to lighten our load when life happens. However, protecting ourselves with the instruments doesn’t free us up to carry massive amounts of debt.

Certain debts are just plain stupid. S-T-U-P-I-D! For instance, consumer debt that I’m borrowing to increase my lifestyle. Or credit card debt which is not paid for. Debt to buy new cars (this post is coming)! Taking a vacation that you go into debt for is not a vacation! Understand debt and when it can be beneficial. Don’t use debt just because you can.

There is not a one size fits all! Everybody is different. I have friends that are comfortable with a 90% debt to asset ratio. I am not. I want a lot of equity in my assets, so I’m only going for a 50-60% ratio. That helps me sleep at night. I know business owners who used debt to purchase and grow their business, and it paid off significantly. Additionally, I know business owners who flee debt like a plague and their business increased drastically. Whether you’re going to use debt or not use debt, really isn’t the point. What I’m advocating is, meet with a CERTIFIED FINANCIAL PLANNER™ that challenges you one way or the other. If you’re comfortable with debt, find someone that is not comfortable with it to help you balance out. Or perhaps you’re like me and hate debt. Then find an individual that is comfortable with debt. BALANCE! BALANCE! BALANCE! Finances are emotional, so find your balance and make informed decisions concerning debt.