Why Debt Infinitely Trumps Savings
The formula the rich use to grow their money exponentially
Is there anything more symbolic about teaching kids about money than this image?
Or perhaps if you were of an older generation, you think of this:
The myth of savings as a means to get rich
There's no doubt about it, from an early age we teach our children the value of saving money. "A penny saved; a penny earned," we chime. And when they are a bit older, we spin tales of the magic of compounding interest. Save enough, children are told, and you'll be a millionaire by the time you're ready to retire!
Of course, we don't tell them about historically low interest rates, or the power of inflation to eat away at the value of money over time so that being a millionaire is worthless by the time you retire. Those are inconvenient financial truths.
It seems as if the "wisdom" to save your money is timeless, in that it won't go away, even though it's proven to be wrong. Even today you find "financial experts" who push the save to be a millionaire myth.
Playing with numbers
Take for instance this video shared on Business Insider, "How much money you need to save each day to become a millionaire by age 65". Breaking it down by age, it gives the following amounts:
- Age 55: $156.12 per day / $56,984 per year
- Age 50: $73.49 per day / $26, 824 per year
- Age 45: $38.02 per day / $13,879 per year
- Age 40: $20.55 per day / $7.500 per year
- Age 35: 11.35 per day / $4,144 per year
- Age 30: $6.35 per day / $2,317 per year
- Age 25: $3.57 per day / $1,304 per year
- Age 20: $2.00 per day / $730 per year
If you're in your twenties or thirties, you're probably feeling pretty good about these numbers. You might even be tempted to think it's worth it to start saving your money. After all, who doesn't want to be a millionaire by the time they're 65? If you're in your forties or fifties, you're probably looking at those numbers and feeling a huge pain in your stomach. I don't know many middle class families with an extra $10K to $56K to save each year.
Now, here's the kicker, at the end of the video, the following assumptions (or should I say disclaimers?) are given:
"For simplicity sake, the calculations assume a 12% annual return and don't take taxes into account."
That indeed is some magical compounding interests-and mythical too. Let's break this down a bit.
What's a realistic return?
In the last 30 years or so, there has only been one time where interest rates on CD's reached 12%. That was for a 5-year CD in 1984. Over the last decade, the S&P has only returned 8.65% on average. In the same time period, the 3-month T-bill has returned 0.74% and the 10-year T. Bond has returned 5.03%. In fact, if you look at this chart by Aswath Damodaran, you'll see that since 1928, you'll be hard-pressed to find any standard investment or savings vehicle that returns 12% over a sustained period of time.
Perhaps you're ready to concede the point that 12% is lofty in terms of return assumptions, but maybe you're still pretty comfortable with the idea of a 10%, 8% or even a 6% return. The problem is not only does the video assume a high rate of return that most people will never achieve, but it also does not factor in taxes, which can eat up significant portions of your returns. For instance, savings account interest is taxed at a marginal rate. This simply means that it is taxed at your income bracket. So if you're taxed at a 25% rate for your income of say, $65,000 a year, you're savings interest earnings are also taxed at that rate.
You can begin to see how this pop financial advice begins to quickly fall apart.
Savers are losers, but who is the winner?
For years, I've preached that savers are losers. Hopefully the examples above will open your eyes as to why.
But the question becomes, why would financial advisers continue to push savings? As always, follow the money. The traditional vehicles by which most people save allow for financial institutions to charge fees. These fees can be especially devastating to a retirement account like a 401(k). Take this example from "USA Today":
Let's say, for instance, you save $10,000 a year for 30 years in your 401(k). If you average 7% returns annually and pay 0.5% in annual expenses, you'll finish with about $920,000 saved. However with 1.0% in annual fees, that total drops to a little less than $840,000 - and if you suffer 2.0% in annual fees, your finishing total is just under $700,000.
Adding them all up together, lower returns that most models assume, losses to taxes, and payouts to financial institutions in the form of fees completely decimates the assumptions made by the Business Insider video, and frankly, most savings models out there. Savers truly are losers, and it's the financial institutions that win.
Bad debt vs. good debt
So, if savings isn't the way to become rich, what should you do?
The short answer is go into debt.
Maybe that answer surprises you. After all, you've probably been told since you were a child that debt was bad. And it can be. But it can also be good-very good.
Let's take a moment to define what I mean by bad debt and good debt.
Bad debt is money that takes money out of your pocket. It makes you poorer. This can be credit card debt from purchases for things like clothes or TVs. And it can even be the mortgage for your personal home. In short, if it's not making you money, it's bad debt.
Good debt is another story, and most people aren't even aware that it exists. Good debt puts money in your pocket month in and month out. "How can this be?" you might ask. Glad you asked. Let's talk about a concept called OPM or Other People's Money.
How good debt works, aka (OPM)
The rich know how money works. They understand that the best way to get a high return is to have as little of their own money in a deal. Rather, they spend their time finding the best deals and then present them to investors who are willing to use their money to fund the deal. When structured right, OPM allows an investor to secure a valuable, high return, cash-flowing asset for little-to-nothing.
As an example, let's talk about Rich Dad investor Ken McElroy. Ken, as you may know, is a real estate mogul specializing in apartments-a real estate class called multi-family housing.
What Ken and his partners do is find apartment buildings that underperform. Because the value of a commercial real estate asset like an apartment is based off the Net Operating Income (income after expenses), any opportunity to increase NOI is an opportunity to see a healthy return.
For Ken and his team, a variety of factors could help with this. For instance, the current landlord could be renting units well-below market rates. Turning those units and raising the rent could dramatically increase NOI. Or perhaps retrofitting units with washers and dryers, as well as a cosmetic facelift could increase rents by anywhere from $25 to $50 a month. Multiply that by hundreds of units and you'll see a lot of lift in income.
Once they have a solid business plan in place, Ken and his team to investors and raise the capital they need to purchase the property (OPM). Once the asset is secured, they execute on their plan, as well as bring their considerable management expertise to the table.
Already, both Ken and his investors enjoy a good return from the property income since they only purchase cash-flowing assets. This can often be in the double digits. But here's what separates the rich mindset from the poor one.
Once the property is substantially increased in value from the business plan, say over a course of three years, Ken and his team refinance the property, pay back all the investors their original capital plus a generous return on that capital, and still have ownership in the building that cash flows each month. And the beauty for Ken and his team is they create this wealth with a little bit of their capital and a bunch of capital from other people. So their returns are higher the whole way through.
At this point, Ken and his investors are enjoying income with no money in the deal. That is an infinite return. And that is why debt infinitely trumps savings.
The good news is you can begin to invest like this. It might now be with large apartment buildings at first, but it can grow into that. My wife, Kim, invested with OPM for her first investment-a rental house in Portland, OR. Today, she owns thousands of apartment units. She used this method of good debt to increase the velocity of her money from one small house to a huge portfolio. And you can too. It starts with thinking differently about money, increasing your financial intelligence, and getting to work today.