Happy Day to you. This is Ken Kaufman and I am thrilled you’re here for Episode Number eight, terminate debt.
As you’ll recall, we’re working our way through the impact your net worth model using impact as an acronym, and each letter of that acronym represents one of the six key principles for building net worth and getting ahead financially. As a quick reminder, here they are:
I is for iterate mindset and process. M is for maximize income and joy. P is for prioritize the waterfall. A is for align with partner and waterfall. And these first four set the table so that we can understand and be prepared to function within the actual formula of net worth, which is simply assets minus debts equals net worth. C is for cultivate assets. We talked about that in the last episode, for each dollar that we are able to put into an asset, a bank account or an investment portfolio or a retirement plan at work or real estate. For each dollar we put in, our net worth goes up by $1. And today, we’re going to talk about T which is for terminate debt. This has the exact same impact only when we take $1 to pay down debt, it makes our net worth go up by $1. So very simply, as we increase our assets, we will drive net worth up and as we decrease our debt, we will also drive net worth up into the right.
The other thing we do and we pay off debt is we start to reduce the amount of risk that we’re exposed to. When I thought about what we should talk about in the area of terminating debt, there’s one key principle that I think is misunderstood. And I hope that this will help you understand what debt should actually be used for, where it does make sense, and the potential negative impacts that come when you employ it anywhere in your personal finances. So here’s the key principle, debt magnifies financial outcomes for the better or for the worse. Once again, debt magnifies financial outcomes.
I want to share just a couple of examples to help you understand how this works. Let’s suppose that you want to buy a home and the home that you’re really interested in purchasing costs $100,000. Yes, I know there aren’t many homes for sale for that amount. But we’ll just use that number as a nice easy round with lots of zeros to work with.
And as you’re preparing to buy this home, you have a total of $50,000 available to you in your bank account to be able to help pay for it, you need to borrow the other $50,000. Well, this is interesting. And it’s great in many ways, because debt allows you to get access to something that you couldn’t have had otherwise, you would have had to settle for that $50,000 house otherwise.
However, it also means that you’re going to have to take on a payment because that lender is going to want to be able to earn some rate of return. And there will be payments and all of those things that go with it. So you go through this transaction, you buy this home, and you now take $50,000 from your own bank account and put it into the house. And then you borrow the $50,000 from the lender and you now have a mortgage. Now, again, just for the sake of this example, let’s suppose that the lender charges interest only loan for 10 years, that means you’re just paying off a nice interest amount. And let’s say it’s 6%, just to pick an easy number, that’s $6,000 a year, or $500 a month that you’d be paying on this loan over the course of the 10 years.
So now, at the end of 10 years, you decide All right, I want to sell this home, and the home is now worth $200,000. Well, you put $50,000 in. And if you can sell the home for $200,000, you think wow, that’s an amazing return. However, you still have that $50,000 that you need to pay back to the bank, which is fine. That means now there’s $150,000 left for you, after you kept up with those interest payments. So that means your $50,000 investment in that home became $150,000, or three times your money invested. That’s incredible, you never would have had that opportunity without that the ability to take on that debt. And in fact, had you had $100,000 that you put in of your own money, you only would have two times your money because you would have gotten $200,000 back but in this case, you three times your money. So this is where debt magnifies financial outcomes for the better.
Now what happens in this scenario, if you lost a job, or your income went down, or there were some financial tragedy that happened in your life or your family’s life, that you needed to be a part of solving, and you weren’t able to make your payments? Well, after a little while the bank will get frustrated that they’re not getting paid. And because they took a security interest or collateral in your home, they have the ability to come in and foreclose and take that home away from you. And if that occurred, you would lose all $50,000 that you put into that home, of your own money, of your own cash.
That also is an example of how debt magnifies financial outcomes where you could actually lose everything that you put into it, or it was all at risk. Had you just used all of your own money, if you had $100,000 to buy the home, this never would have been a risk, you didn’t have any payments, you didn’t have any lenders with the security interest. And you would have gotten a return, but it wasn’t as great as with the debt present. But the debt presented some additional risks. And with those risks, there were magnified financial outcomes again, for the better for the worse.
Let’s use another example. Let’s assume you’re sitting there debating about going back to school and getting a graduate degree. This assumes you’ve earned an undergraduate degree already. And you’ve done some research. And I did a quick search. And it turns out that on average, in the United States, people who have a graduate degree as opposed to an undergraduate degree, earn on average $17,000 more than someone with just an undergraduate degree. And again, nothing wrong with having an undergraduate degree or not having any degrees, just using this as an example. So let’s say that you decide to go back to school because you have confidence that you’re going to be able to increase your income over some period of time.
So again, just doing a little bit of research, I picked $50,000 as a round number as the cost of this graduate education might be able to get that done for 20 or 25,000 dollars. There’s other graduate programs that are well over 100 thousand dollars. So just picked 50,000 as a nice, clean number to work with. Let’s assume that you have that $50,000 in the bank, and you go through that education process, you come out of school and right away, you start making $20,000 more than you did before you received that graduate degree. Well, that’s amazing. Over 10 years, that means you will have earned $200,000 on just your $50,000 investment. And I should say $20,000 10 years from now, based on time value of money, tells us that it’s not worth as much as $20,000 today. So using a formula called internal rate of return, it shows us that you actually generate a 38% annual return on your money for the $50,000 that you put in to your education. Besides the fact you’re investing in yourself and in your opportunities to learn and grow and develop and provide additional income. So that’s a nice clean way with no debt involved.
But say, instead, you go back to school, and it’s going to be $50,000. But you decide that you don’t want to put any of your own money toward it. And you’re going to borrow all of the money to accomplish that, still hoping for that same outcome of $20,000 a year of additional income.
Assuming a 6% interest rate, your loan payments are going to be roughly 6,500 a year, it’s a little bit more than $500 a month just to give some context.
So the $20,000 extra income you earn a year after you graduate with this graduate degree is now worth about $13,500 instead of the full $20,000 because you’re making these debt payments along the way. Now, here’s the interesting thing. If you had started earning that $20,000, there’s no hiccup or any issue and you stay employed the whole time, you end up earning an extra $136,000. Again, taking the $200,000 over the 10 years, you earn an extra $135,000 because you have to take out those debt payments. So $200,000 minus this total debt servicing cost of about $65,000. That leaves you $135,000 left, and look at what your return is – you put none of your own money. Sure, I know you put time and blood and sweat and tears. But from a financial analysis perspective, you did not put a single dime in, so your return on investment is infinity, it can’t be calculated. Because there’s no investment on your part. Well, it’s powerful.
But what about the flip side? What if you came out of school and you weren’t earning any extra money, but now have this $6,500 a year payment? What if you lost or had a hard time finding a job and it took a couple of years before you found the right opportunity? Well, again, you have that debt payment in place, or you have a disability or you have other things that happen that impair your ability or perhaps eliminate completely your ability to earn an income moving forward? Yet you have this debt outstanding, the start missing payments and in the case of education will hit your credit score. And there can be a lot of painful outcomes from that. So when you introduce debt into this scenario, it magnifies outcomes, it can make this infinity return available for you. Or it can also ultimately ruin your credit and create a bunch of financial problems and, really, a financial crisis for you because you can’t keep up with servicing the debt. Whereas if you just paid for it all yourself, you get to keep all the return you generate. And you’ve eliminated the risk, but there’s no magnification of outcomes. It’s just a straight, clean outcome.
So taking these two examples now, and understanding this concept of terminating debt, every dollar that we pay down debt with, we are increasing our net worth.
I should back up to the heyday in real estate back in the mid 2000s when there were people buying up real estate all over, I had friends who would tell me, I’m a millionaire, I now own a million dollars worth of real estate. And I would tell them great, that’s awesome. Tell me about how much debt you have on all that real estate. And they’d say, Well, I have basically a million dollars of debt on all this real estate. Well, assets minus debt tells me their net worth actually didn’t go up by a million dollars, it was a zero impact transaction that they went through there. And yet they expose themselves to a whole bunch of risk. And everyone that I know that was in that shape in that condition did not survive the financial crisis that happened in the late 2000s, some had to file for bankruptcy, and some got in trouble with federal authorities and ended up even spending time in jail over different partnerships and different things that happened. That is a magnification of outcomes for the negative.
Now, if real estate had kept going up, and they were just completely leveraged, then they could have made these amazing returns without having to put any of their own money in or maybe just a little bit of their own money in. So I realize and recognize that it could create a great or a bad outcome just depending on how things go.
When it comes to our personal finances, we want to be so careful if we’re working so hard to gain assets and gather and build assets. And we’re working hard to keep our debt as low as possible. We want to ultimately eliminate our exposure to debt, not because we don’t want the opportunity for any arbitrage or the magnification of outcomes. It’s because we ultimately want to de-risk so that our assets are not exposed to these potential risks. Like if we lost employment, and we have all this debt that we have to pay for, well, now we’re gonna have to start depleting all of our assets to make all of those payments over however long the period is when we can go back to work.
So this is very conceptual, very big picture. I’m not going to take time in this podcast to go through different types of debt, consumer debt and auto loans and homes and education and all of those sorts of things. We’ll get into that in a future episode, as well as secured debt versus unsecured debt and how all of these different things work.
The key point to take away and understand is debt magnifies financial outcomes. And when it comes to our personal finances, when we take $1 and we pay down debt, not only do we increase our net worth, but we also take another step toward protecting the other assets that we’re saving. And we are building.
Well, there it is, terminate debt.
And that concludes our review of the impact your net worth model. Now that we’ve actually laid this groundwork by going through the six key principles, we’re ready to start taking a deep dive into various areas of personal finance that will allow each of us to build financial freedom and improve our net worth. In our next episode, we’re going to actually jump into how do we track net worth, what are the mechanics behind it, the frequency, and so on. So if you have any questions, feel free to send them my way. And I’ll make sure to try to include those in the next podcast.
And also please make sure to subscribe to the podcast so that you can get all of those tips and tricks and hacks on how to track your net worth. And if you feel so inclined, I’d appreciate you leaving a review to let me know what you think of the content and if there’s anything that I can do to improve it.
Many, many thanks to you for joining today. This is a wrap for episode eight. Happy Day.
Transcribed by https://otter.ai