In his new book, The Value of Debt in Building Wealth, Thomas J. Anderson argues forcefully against the conventional wisdom that all debt is to be avoided.
“I know we can embrace a sensible, balanced approach to debt. This approach will increase your financial security and flexibility. It will increase the likelihood of a secure retirement, and reduce your stress along the way.’’
Anderson is founder and CEO of the Chicago-based firm, Supernova Companies, which sells software explaining how low interest loans backed by securities portfolios can increase investor returns.
A former advisor and investment management analyst with Morgan Stanley and Merrill Lynch, he is emphatic about who is likely to succeed in his four-tier plan for harnessing debt to enhance wealth, known as L.I.F.E.—launch, independence, freedom, equilibrium:
“This plan requires discipline and requires you to be rational and thoughtful,’’ he says.
Succeeding with L.I.F.E also requires that its practitioners and their advisors accept Anderson’s views on investments. He says his research shows that most Wall Street portfolios have more than 80 percent of their assets in U.S. stocks and bonds—“an allocation to two assets that are trading at or near absolute and relative all-time high prices.’’
But if this bullish market turns bearish in the next five years, Anderson says, “there is a high probability of below average and potentially negative returns in U.S. stocks in that five-year period. I am not saying investors should not own U.S. equities or that they shouldn’t own cash or bonds. I am saying if your portfolio is only composed of these assets you may have a difficult time capturing a spread for the next decade.’’
To avoid that trap, Anderson says, “consider taking your risk through a balanced amount of debt rather than through asset allocation. Tune out the news and market forecasts. Nobody knows what will happen in the future.’’
Readers likely to gain the most from The Value of Debt in Building Wealth are 25 to 40-year-olds with enough working years ahead to make significant savings toward retirement. Advisors might suggest the book as a source for clients interested in leveraging good debt and escaping destructive debt.
Anderson starts with the basics—get rid of oppressive debt (credit cards); consider renting rather than buying a house until there is no oppressive debt and net worth is at least 50 percent of annual income, and closer to two times annual income.
On borrowing, Anderson says aim to “keep borrowing costs as close to inflation or inflation + 2 percent. If they get above inflation + 4 percent, it will be hard to capture a spread.’’ Avoid 15-year mortgages (unless there is steady cash and, savings of at least 15 percent annually); interest-only mortgages work best when savings are at least 15 percent annually; 30-year mortgages are good if the buyer remains in the house for at least five years.
Goals for the launch phase are to eliminate oppressive debt; have cash reserve equal to one month’s income; start retirement savings. Those paying student debt should equally save at least 15 percent of annual income.
By the end of the independence phase, no oppressive debt exists; there is three month’s income in savings, one month in retirement savings, and a “big life changes’’ fund (home purchase, wedding, graduate school) equal to a nine month cash reserve. Anderson introduces debt ratio and compounding here, and says ratios can be reduced by increasing assets, not paying down low-cost, working debt.
“This gives a larger base of resources, which will increase your liquidity and flexibility and enable you to capture the spread or earn a rate of return on your investments higher than your after-tax cost of debt,’’ he says.
Reducing debt ratio, saving toward retirement and enjoying life are the freedom phase goals. A case study couple, with an interest-only mortgage, reduced their debt ratio from 65 percent to 38.1 percent because their cash, personal assets, long-term investments and retirement investments grew significantly. Until net worth is more than five times annual income (equilibrium phase), “paying down debt should be off the table,’’ he says.