With Tom Anderson, Author of The Value of Debt and Building Wealth
Save or Pay Off Debt?
Tom Anderson, author of The Value of Debt and Building Wealth, joins Steve to talk about the potential benefits of debt in terms of managing your retirement income, when debt should be “extinguished” as quickly as possible, and a variety of nuances in these and other scenarios.
The conversation begins with Steve’s observation that many folks, especially those under 40, see debt as a “four letter word,” something to avoid like the plague if possible. He speculates that this outlook is a hangover from the housing bust in 2006 which resulted in thousands of underwater mortgages where people owed more than the value of their homes. Foreclosures and job losses cascaded into further loan defaults and bankruptcies. Steve asks whether Tom believes that the time has come for this generation—as well as others—to reconsider their view of debt as an inherently risky gambit and unnecessary burden.
Anderson answers in the affirmative, though he’s quick to add that not all debt is the same and that he would never recommend piling on debt for its own sake. Instead, he argues that the generation that witnessed the housing bubble collapse should value flexibility and liquidity when thinking about debt. Flexibility, in this case, means being open to using debt as a tool in the right circumstances, and liquidity is access to cash for an emergency reserve or other needs. Anderson argues that people are generally too aggressive—or inflexible, so to speak—about paying off debt to the exclusion of liquidity.
Anderson takes pains to ground his advice about debt in the reality that “staggering” debt permeates our society at levels higher than it ever has. His conviction is that a “thoughtful, comprehensive, balanced approach” towards debt is needed which can guide individual decisions about when to pay down certain kinds of debt. On a more sophisticated level, this approach can inform our overall financial planning, retirement savings, and asset allocation strategies.
Pay off mortgage or invest?
Steve explains that one of the most common questions he’s asked as a financial advisor, and one that comes up frequently on this show, has to do with the wisdom of paying off your mortgage before you retire. Tom’s reply is more nuanced than a simple yes or no. He begins by categorizing debt into three types: oppressive, working, and enriching debt. For the most part, these categories are based on the interest rates of the loans in question. Anything over 8% annually is oppressive, according to Anderson. Credit card APRs are often higher than 8% and frequently double that and are, therefore, an obvious candidate to be paid off as soon as possible. Mortgages, on the other hand, are typically much lower—especially those written in the 8 or so years since the Federal Reserve cut interest rates to near zero or those refinanced during this time. If your mortgage interest rate is around 2-3% after taxes (or 4-5% before taxes), Anderson asserts that it would be better to build up your savings than pay off the mortgage. The reason is that your savings, invested in a diversified portfolio that approximate market benchmarks, will be compounded, meaning that those savings will grow faster than your debt. Most people will benefit more from a strategy of saving/investing than paying down debt early.
Pay off mortgage before retirement?
Steve points out that many of his clients are fixated on paying off all their debt and owning their homes outright based in part on anxiety about having any debt and in part on a notion that financial security can be gained by home ownership. This belief persists despite the fact that these people would have very few assets and little cash if they were to pay off all their debts. While some expect they could pull equity out of their homes in a second mortgage or HELOC, Steve warns that these type of loans may not be available to people of a certain age. Anderson follows these observations by suggesting a paradigm shift of sorts in the way people look at debt and retirement planning: Instead of looking at mortgages and other loans as the full picture of the money you owe, consider your retirement savings as a debt you have to your future self. The only people who can afford to chuck all debts aside are those whose net worth is 20-30 times their annual income.
The conversation returns to the importance of liquidity. Again, the main takeaway is that choosing to pay debts to the exclusion of keeping enough cash on hand can have unforeseen negative consequences. Anderson briefly outlines scenarios where you’ve put all your funds towards paying off debt and then you lose your job. Pulling cash out of paid debts is usually very difficult if not impossible. The more liquidity you have, the more flexible are your options when it comes to taking on new debt if needed.
Tying together a few strands of their talk, Steve concludes the interview by describing a hypothetical situation in which a person has a $250,000 mortgage and $250,000 in cash. The question is whether this person can make a large enough return on their cash (by investing in stocks, for example) to justify not paying down their mortgage early. Steve refers to a quote from Michael Kitces, in an article written by Anderson, which says that you’d need a 10% average annual return on investments to warrant this approach. Tom’s reply is that the smaller your (liquid) asset base, the greater the return needed to meet savings goals. In fact, if you’re unbalanced in terms of debt to liquidity, you could be setting yourself up to need a high annual return in the neighborhood of 12%, a very steep target. A more balanced strategy that expands your asset base would alleviate some of the pressure to achieve outsized returns.
Steve Pomeranz: One question we constantly tackle on this show and in my practice, people believe that you should enter into retirement without a mortgage. The actual answer is much more nuanced. To discuss this and other matters related to understanding how to think about debt, I want to welcome Tom Anderson, author of The Value of Debt and Building Wealth. Hey, Tom, welcome to the show.
Tom Anderson: Hey, Steve, thank you very much. I really appreciate it; great to be here today.
Steve Pomeranz: For many adults, especially under 40, debt is still a four-letter word, something that should be avoided but is sometimes just unavoidable. I think this age group’s attitude is based on when they came up in the world, which can have a powerful impact on your beliefs. They came up in a world where the 2006 real estate crash found so many people owing more on their homes than their home was worth. Do you think it’s time for this age group, and maybe for some other age groups, to reconsider and rethink this idea of debt?
Tom Anderson: Absolutely, I do. First of all, I don’t think that all types of debt are good nor is this about just going out and getting debt for debt’s sake, but I think what we learned from the financial crisis—especially for the group that you’re specifically talking about—is that they need to value liquidity and flexibility. Sometimes, I think in our anti-debt culture, people are in such a hurry to get rid of debt that they don’t focus on building up that emergency reserve so that they can get through the next crisis.
Steve Pomeranz: Yeah, I want to talk about that. We see that a lot. A lot of people in their 50s and 60s are more comfortable having debt. They’ve had mortgages for a long period of time. Even though I noticed in one of your articles or an article that you were quoted in, the amount of debt that people have now is a lot greater than it was, let’s say, 20 or 30 years ago.
Tom Anderson: There’s no doubt. People are using debt all the time. People use it to get through school; they put debt on their credit card; they use debt to buy cars; they use debt to buy homes. The amount of debt is staggering. If we’re going to have debt in our society, we need to have a thoughtful, comprehensive, balanced approach to when are we going to pay down what types of debt and how does that debt fold into our asset allocation strategy and our overall financial plan?
Steve Pomeranz: Well, let’s get to this question as to whether debt is something, or mortgage debt, particularly, is something that you should extinguish prior to retirement. When is it a good idea? Let’s start with that, Tom. When is it a good idea to extinguish your debt before retirement?
Tom Anderson: Yeah, I break debt into three different categories, what I call oppressive, working, and enriching debt. If you think about it, oppressive debt would be things like credit cards, any debt in your life that’s at a rate greater than 10%. I frankly say any debt at a rate over 8% but if you have credit card debt at 15%, you want to extinguish that as fast as you can. You’ve got to get rid of that.
Steve Pomeranz: Okay.
Tom Anderson: To your direct question, if you have a mortgage and, let’s say, that rate is at 4% or 5% and maybe you’ve even got it locked in lower, as some people did over the past couple of years here, maybe your tax advisor says to you that that’s fully tax deductible. If your after-tax cost of that is 2 or 3%, you might not want to rush in to extinguish that before retirement until you have built up enough savings. I think so many people just pay down that debt early and then try to save later. What I would basically suggest is doing the opposite. Build up your savings early. Let that money compound for you and then you can pay down your debt later.
Steve Pomeranz: Yeah, I would totally agree. I mentioned this word “nuanced” before and people come to me, and they have this in their mind, “I want to be debt free. I want to own my home. I don’t want anybody to be able to take my home away from me.” Yet, when I see their balance sheet or their net worth, I see they don’t really have the assets. Maybe all you have is the amount to pay off your debt with a little bit left over. What are you going to use to live on? What if there’s an emergency? How are you going to handle that? You might decide, “Well, maybe I’ll pull the money back out of my house with a home equity loan,” but sometimes that’s not even available to you anymore.
Tom Anderson: What you’re talking about is the most important thing for financial advisors to address with their clients. It is nuanced; that’s the best word. What I would say that most people feel like when they have a debt against their house, it maybe makes them feel uncomfortable. I understand that, but what people need to understand is that they also have a debt to their future self. They have an unfunded pension obligation. If you want to retire, you need to build up assets to be able to fund that retirement. When your net worth is greater than 20-30 times your annual income, if you make a $100,000 and have a net worth of more than $2 million dollars, you might not need debt. But if your net worth is less than that, you need to build up assets to have any shot of making it in retirement, exactly as you said.
Steve Pomeranz: Wow! I love that, “You have a debt to your future self to fund your retirement.” That’s a great concept, a great way to look at that. If it’s a debt to your future self, maybe, in that case, you can actually make the case that not all debt is bad, especially the debt to your future self, you know? That’s a good way to look at it.
My guest is Tom Anderson. He is the author of The Value of Debt In Building Wealth. He’s a well-educated individual and knows what he’s talking about here. Liquidity, like you mentioned earlier, this idea of having enough money for emergencies and to fund this debt to your future self is important. If you have enough liquidity, then maybe paying off your debt is a good idea. What are some of the danger signs that you should look for with regards to this idea of having not enough liquidity? How do I know whether I have enough liquidity?
Tom Anderson: Well, what I think is interesting is if we look at conventional wisdom and start, even with what you said and kind of back in the last crisis, most people are slamming money into their retirement plan and then racing to pay down debt as quickly as they can. What I think is important is that they value liquidity. The danger sign is, why is so much of America in this check-to-check environment? I think we all have other crises and that 2008 won’t be the worst that we see, but let’s look at that. If I pay down $50,000 on my student loan and I lose my job, I can’t get that money back. If you pay down $100,000 on your house and you retire, it’s hard to get a mortgage without a job. Or, if you lose your job, you don’t have access to it. If you have $10,000 in the bank, even if you have some debt, that can get you through a pretty big crisis. $50,000 gets you through a bigger crisis and, if you have $100,000 of liquidity, you can ride out any storm, which is what…money is what creates so much of the pressure in our life, and I think it’s because our anti-debt hysteria. I’m willing to have cash and debt in my life if I have more liquidity and flexibility.
Steve Pomeranz: You know, if you have enough money and you take a look at your home as an investment versus other investments…let’s say you’ve got a $250,000 mortgage, let’s say you have the $250,000. You go, “Well, let’s see. I pay off my debt. That means I’m going to get a guarantee of whatever the rate on that debt would be. Let’s say it’s 4%. Now I’ve got a 4% guarantee by paying off my debt, so that’s cool.” Then you go, “Well, what else can I invest that $250,000 in? I can go into the stock market, which should have a higher return over time of 4%.” But you make an interesting point with the quote from Michael Kitces in your article that, actually, you need to get over a 10% rate of return on your stocks, I guess on a risk-adjusted basis. We only have a minute left. Can you describe that idea a little bit?
Tom Anderson: Yeah. I think what happens is, as we get closer to retirement, what matters is, what’s that base of assets that we have that’s working for us? If I have a large base of assets, then I can actually have a lower return and be on track. If I have a very little base of assets, then I need a really high rate of return. While these ideas get more complicated and nuanced, the theme is, it’s what you said before, you pay off your house and you want to create all of your income from that small remaining base of assets. I walk through it in the book and I say it might not be possible with a 12% rate of return. But, if you embrace a balanced approach, you can actually have lower returns and, therefore, a higher probability of success.
Steve Pomeranz: Yeah.
Tom Anderson: What this book is about is just setting a bar for the highest probability of success to accomplish your dreams.
Steve Pomeranz: All right, Tom explains the nuance. My guest is Tom Anderson, author of The Value of Debt in Building Wealth. To find out more about Tom and to hear this interview again, join the conversation at Steve Pomeranzpomeranz.com, P-O-M-E-R-A-N-Z, Steve Pomeranzpomeranz.com. Hey, Tom, thanks so much for your time.
Tom Anderson: Hey, thank you, Steve, really appreciate it.