How it Works
I’d like to help you understand two things:
The first is how debt can help you keep up with inflation.
The second is how important this concept is to your future.
I didn’t fully understand the idea that debt can help you keep up with inflation until a few years ago. I had gone to many classes, and I had heard that debt can help you. Conceptually, it made sense. But I didn’t gain true working knowledge about how debt can be beneficial until I saw an example that made sense to me.
I am, as my husband affectionately calls me, a “spreadsheet geek.” So to help myself understand this concept, I created a spreadsheet. When I ran the numbers, suddenly it was all perfectly clear.
Now I hope to demystify this concept, so you, too, can be empowered in your financial planning.
Inflation
Let’s begin by talking about inflation. Inflation is how we measure the cost of living today versus the cost of living in previous years. We can use this information to plan. If we can calculate our future cost of living, when we reach our retirement years, we’ll know we can afford to maintain our lifestyle. In other words, by accounting for inflation, we should be able to predict how much money we will need to live well later in life.
Current reporting in the Consumer Price Index (CPI) is low because, as of the 1980s, they no longer measure full inflation for out-of-pocket expenditures. The most recent data based on a CPI that does show accurate numbers and measurements are reported in ShadowStats. To help you understand how much it will cost to maintain your lifestyle in the future, I will use numbers from what is believed to be the most accurate measurement of how inflation will impact us.
Debt
How can debt help you? Debt sounds like a bad word, and indeed, debt can be very dangerous. But there is bad debt and there is good debt. When credit cards are used at the drop of a hat, or in some cases, to live on, the outrageous interest rates can add up fast. In no time, you’ll be so far behind that you can’t get ahead of the debt you’ve incurred. Let me be very clear: this is not the type of debt I am talking about when I say debt can help you keep up with inflation. The debt we are talking about, Strategic Debt, is good debt. Strategic Debt can work for you and make you money.
Strategic Debt has four attributes. This is debt that you can get:
- At a reasonable, fixed interest rate
- For a lengthy term
- With no pre-payment penalty
- On an appreciating asset
Not applying these four attributes when you take on debt is how good debt can turn into bad debt. Let’s take a closer look at these four key debt requirements.
Key Debt Requirements
Fixed Interest Rates – A fixed interest rate is important because having it means you can plan your payments for the length of the debt. You don’t want your interest rate to increase as inflation rises. You want your payment to be predictable, so you know how much you will need to cover at any given time.
Term Length– Term length matters because a fixed-rate loan with a longer term will have lower payments. This means you can lower your payment by adjusting the length of the loan so you feel comfortable making the payment. However, the longer the term, the more interest you will pay. You can also figure out exactly how much you will pay for the debt, including interest, over the term. If you decide to pay off the loan early, you’ll be able to calculate how much you will save.
No Pre-payment Penalty – You always want the option to pay off a loan early, and you don’t want to be penalized for it. As discussed above, you can ensure you are always able to afford the payment by having a longer-term loan, and thus a lower payment. If you want to pay off the debt before the end of the term, pre-payment penalties can dramatically increase the cost of the loan, turning good debt into bad debt.
Appreciating Asset – If you are using debt to keep up with inflation, it is very important to use that debt to purchase an appreciating asset. An asset that increases in value allows you to offset the cost of the debt and leverage your cash in a way that makes using debt a strategic advantage in keeping up with inflation.
Real Estate
For our good debt example, I’ll use real estate as the asset. An investment does not have to be in real estate, but we can get good debt in real estate while meeting all the key requirements described above. Another reason I like real estate is that it can provide either Income or Appreciation. Often, it can provide both.
Illustration
Please follow along using the illustration below.
In the example, I am going to use something we can relate to, an expensive bottle of wine! We will look at how much it costs to buy this bottle of wine today versus how much will it cost to buy in five years, and whether we will still be able to afford it. No matter what the commodity, you must be able to afford it to keep your family in the lifestyle to which they are accustomed.
For our example, say the bottle of wine costs $4,000.00 today and $5,049.91 in five years, due to inflation. We want to know if strategic debt can be used today to help us afford the $5,049.91 bottle of wine in five years.
For the purposes of our explanation, we will use today’s inflation rate of 6%, taken from ShadowStats. Our example tax rate will be 22%, based on the new tax laws, and our example appreciation rate will be 7%.
Please note: All real estate markets and assets are different. It is important that you understand the average appreciation rate for your asset in your market. Please see our spreadsheet to see how the percentages apply to the numbers.
Two scenarios to see if we can afford the bottle of wine:
Scenario One
In the first scenario, we’ll use our own cash and no debt to purchase a house for $20,000. Using our 7% appreciation, our house will be worth $26,215.92 in 2022. If we sell the house at that point, we would pay
$1,367.50 in taxes, which is 22% of the $6,215.92 profit. The total amount we would make on the house after taxes is $4,848.42, a return of 24%. If the bottle of wine costs $5,049.91 in 2022, could we buy that bottle of wine with the proceeds from selling the house?
Scenario Two
In the second scenario, we’ll use $10,000 of our own cash and $10,000 of debt to buy a house worth $20,000. Because we still have $10,000 left of our own cash, we can buy a second house, also worth $20,000, using the same cash-to-debt ratio. Since we used debt in this scenario, we have to pay 6% interest, but we also get the interest tax write-off. Over five years, we will pay $2,400 in interest for that $10,000 debt, but after writing off the interest, we will only pay $839.50 in taxes for each of the houses. In the second scenario, we will make $5,952.84 in total proceeds for both houses. By strategically using our cash and the debt together, we could buy the bottle of wine in 2022 with the proceeds from selling the houses.
Example Table
Time Impacts
When investing, many people believe, for good reasons, the shorter the investment time, the better the return. Shorter investment times can also reduce your risk. Getting your money back quickly allows you to lock in your profits and re-invest.
On the flip side, this investment method has potential problems. Finding good short-term investments is more difficult. And when you get the investment and return, you have to find another investment. If your money is sitting in a bank while you search for other good investments, that money isn’t doing its job of increasing your profits and keeping up with inflation. Choosing longer-term investments may be the best thing for busy
professionals short on time. We know how much time our company spends on due-diligence. It is unlikely individuals have the resources or experience to commit to the process in perpetuity.
Reserves
We would be remiss if we didn’t talk about the vital importance of keeping some money in reserves. Reserve funds are money set aside for emergencies such as loss of income, medical issues, death, extra expenses, vacancies, etc. Life happens. Countless people have suffered economic hardship because they did not have enough money set aside to weather the storms of life. This money is usually kept in a safe, low-yield savings account, that doesn’t work for you as we’ve discussed. But having these reserves will allow you to qualify for the debt described above. While it is important to keep your money working for you to keep up with inflation, it is also vital to have some set aside for an emergency.
Conclusion
Good, Strategic Debt can be used to make you more money. Using debt to keep up with inflation will allow you to maintain a consistent standard of living later in life. Stay away from bad debt, or debt that can spiral of control because of high interest rates. Good debt is predictable. It is used strictly on an appreciating asset. Good debt has the key requirements of a fixed interest rate, for a lengthy term, with no pre-payment penalty, on an appreciating asset.
THIS IS NOT AN OFFER TO SELL SECURITIES. No securities offering is contemplated herein. Offers for securities are made through a Private Placement Memorandum provided by Company management only.