Capitalizing On Debt Turning Liabilities into Assets Randall E. Davey 8/27/08
In the waning days of World War I, my grandfather returned from the European theatre to his native land of Southeastern Ohio. He borrowed $2,000, married my Scottish grandmother and bought his ailing father’s 87 acre farm, replete with a three bedroom house, out-kitchen , chicken coop, barn and life-stock. His best days financially fell under Harry Truman’s administration when he earned a little more than $3,700 in one year! Still, he managed to clothe and feed his wife and three children, improve the farm and give generously to more than a few charities. He capitalized on debt and turned $2,000 into several hundred thousand [in his late 70’s, they discovered and recovered gas and oil on his humble estate]. Had he not gone into debt for $2,000, he could not have bought the farm [no pun intended]. Arguably, he took on strategic debt which ultimately yielded great reward. Perhaps I give my late grandfather too much credit to think he understood debt as a tool and little more, a means to an end. For the remainder of his life, he was committed to ‘living by cash’ and perhaps that explains why he waited until 1960-something to get indoor plumbing! Admittedly biased, I think this eight-grade graduate was one of the wiser, yet simple, men I have ever known. “Don’t borrow money if you can’t pay it back” he said. Those who survive the current mortgage debacle may want to resurrect that mantra. What is Strategic Debt? Strategic debt is a financial obligation incurred at cost as a means to generating a profit. Here are a few examples:
• In the mid-70’s, northern Ohio was inundated with blizzards, year-after-year. Travelers were at the mercy of anyone with a snow plow and those who had them charged a premium to aid their fellow man. More than a few persons borrowed money to have their trucks fitted with plows because they knew they could recapture their investment and make incredible money in fairly short order. That was strategic debt . . . or so they thought. [In the late 70’s, Ohio went years-on-end without enough snow to warrant
one owning even a snow shovel]. • The Seattle landscape is dotted with coffee kiosks; they are literally everywhere. One can spend $35,000 - $50,000 upfront moving the stands to location, equipping them with appliances and inventory. However, in the coffee capital, investors generally recoup their investment in a relatively short period of time. When one borrows money to make money, that’s strategic debt. • Dr. B, a Pennsylvania dentist, incurred debt when he expanded the number of operating rooms he had in his out-patient clinic. The added space allowed him to triple the number of persons he could see and serve. That’s strategic debt. Ideally, debt driven by additional education, business acquisition, and capital improvement can be strategic. Inappropriately engineered, the same debt can be toxic. What Is Toxic Debt? Toxic debt is – can you say "sub-prime mortgages" and "liar’s loans?" Those who bought homes they could ill afford on the assumption homes always go up in value painfully understand toxic debt. It can kill you. Adding space and equipment to your medical practice without monitoring the number of clients served can increase debt, decrease profitability and invite financial disaster. Racking up debt on 0% interest credit cards with the assumption that one can always switch the balance to another vendor is as dangerous as global warming. Paying the minimum on costly credit cards or paying interest-only on a home equity line-of-credit when that equity was used to buy depreciating assets compromises one’s opportunity to use strategic debt for wealth accumulation. Warning: Your Toxic Debt is Your Lenders Strategic Debt! Think about it. Lenders are in the debt business. It’s not a four letter word to them. That’s why they tease you into becoming credit customers. Two years ago, my wife and I moved from one home to another and the mov necessitated buying new appliances. When we found the selections of choice, I presented my credit
card (on which I carry no balance but on which I earn points ) and the clerk said, “If you buy this on our store’s credit card, we’ll give you zero interest for six months and 10% off the purchase price.” Can you guess what I did? I took the offer. On the way out of the store, my wife asked me how they could afford to knock hundreds of dollars off of the price just because we signed up for their card. You know the answer. They were incenting me to become a credit customer. They count on the fact that the majority of credit card users rarely pay off the balance, faithfully pay interest charges and late fees , which fuel even higher interest rates. Lenders love consumers who focus on how much they can acquire and how little they have to pay, denying the pain of reckoning day. Credit card debt is Strategic Debt for Visa and Toxic Debt for the consumer. Beware of lenders sirens that call out: “No money down;” “No payments for six months;” “Cash back on new car purchases.” Instead, use this equation: "If I buy the car today and try to sell it in six months because I can’t afford it, do I have sufficient cash to cover the spread between what I owe on the car (or couch or lawn mower or whatever) and what it will generate in a quick sale?" When you owe more than your acquisition is worth, that’s called being "upside down" and that’s potentially lethal. When liabilities outpace assets, you may be flirting with bankruptcy. Who is Winning with Your Debt and on Your Dime? In every financial agreement, you can be sure that the financial institution is designed to win ala Las Vegas. It’s no secret that the “house”, the casinos, win far more than they lose. That’s why they can build lavish buildings with opulent decorations and offer high caloric food at tempting prices. Those are the trappings that bring tourist-gamblers inside who laugh while they lose. The “house” is winning with your money. Banks build impressive facilities in key locations, financed by your money. Their business is built on your debt. You deposit money in exchange for a fairly low rate of return and borrow it at a higher rate. As depositors and borrowers exchange money with the bank brokering the deal, the bank profits on the back of toxic debt and admittedly, some strategic debt [mortgages].
In short, banks use money to make money and it’s never “their” money. Their profit is the difference between what they pay and what they charge, coupled with countless fees for “services rendered.” Who is winning with your mortgage? The majority of mortgages to which I am witness compromises the borrower. Ten and fifteen year mortgages are the best examples of loan contracts from which the bank benefits the most. Who is winning with your retirement account? If you put your money in prison [largely inaccessible to you] in a to-betaxed fund, who benefits more? You? The government? The fund manager? Who is winning with your stock portfolio? You assume the risk and you pay the fees and someone else gets paid if the market performs. And why do you do that? Do you really want others to get rich on your money? Is It Possible to Convert Toxic Debt into Strategic Debt? The simple answer is yes. It’s possible. That’s not to say it’s easy, simple or quick. Most of us don’t develop toxic debt overnight and we won’t convert it to strategic debt overnight, but conversion is an option for thoughtful professionals who want to co-create an effective plan. One begins by identifying areas in one’s estate where one is going backwards. Examples: Money under a mattress; money in a non-interest-bearing checking account or low-interest savings account; or excessive equity in a home or office building. Secondly, one examines money vested in underperforming, at-risk retirement funds; inefficient mortgages, college funds and investment accounts. Those are the dollars that may be put to better use if they accumulate in a liquid, competitive account with tax preferential characteristics. These funds may be used to collateralize loans so that you are using your money the way a bank uses your money. Jeff K saved $50,000 in a traditional savings account, “waiting out the market.” He dismissed the paltry sum he received on the account and confessed his disdain for paying taxes on the increase. At the same time, he had a $20,000 outstanding balance on a car loan which he obtained at 7%. Jeff learned how to create a delta between his $50,000 and a simple interest, inexpensive loan to pay off the car. Now, Jeff pays
himself back “with interest,” the same payment he was making to the finance company. He spent no additional out-of-pocket money but he did convert toxic debt into strategic debt. You can too. Keep Money you are presently giving away To maintain control of your financial life and have money work for you rather than against you, here are some tips: 1. Build a team of financial advisors or specialists to consult with. These should include: a. Accountants b. Attorneys c. Consultants d. Financial planners 2. Review your life insurance programs, regularly. Make sure you not only have sufficient coverage but the right kind of insurance that can work with you. Consult with insurance experts, only. 3. Set your goals for short, intermediate, and long term financial success and use the advisors above to help create a PLAN to get you there and beyond. 4. Don’t be afraid of success. You deserve it. 5. Read on the topics above. For example, it’s possible for the lot of us to minimize taxes and maximize cash flow and get a rate-of-return on the back of our debt. Need help getting your mind around that? Read Garrett Gunderson’s “Killing Sacred Cows: Overcoming the Financial Myths that are robbing you of Prosperity”.
Randall E. Davey President Randall@accruWealth.com 425-374-5067w