Introduction & Summary
So let’s go through this, and I want you to understand the difference between an asset and a liability and what out of debt really means to different people. The mega wealthy people, they view it differently than maybe the average American, and this is why you have middle class and you have an upper class who understands how money works. So when we talk about assets and liabilities, simply put, an asset is something that you own or you’re purchasing.
You are owning that, and so you list that on your balance sheet, your statement of net worth. “These are the things I own or I’m buying,” okay? So I may owe something on a house that I’m buying, but I list my assets, but then I also list my liabilities, what I owe. Now, everything that you own minus what you owe equals your net worth.
What is “Net Worth”
Now your net worth will actually grow if you utilize liabilities correctly, and a lot of people don’t understand this because when people think, “Well, I wanna be out of debt,” many times, people’s concept, what they think out of debt means is they have zero liability. So they just list assets and they don’t owe anything. Sounds pretty good, but they have no idea how they are hindering the accumulation of wealth because what makes the world go round is the thrivers who understand when it’s wise to have debt, good debt. Yeah, there’s such a thing as good debt.
So let me explain this here because, when people have come to me now for five decades wanting to get outta debt, yeah, there are smart and quick ways. There are smarter and quicker ways, but the smartest and quickest way to get out of debt,
they’re shocked when I show them the math. It’s not any way, shape, or form sending extra principal payments against your mortgage or against your loan, and people go, “Really? ” ’cause that’s what most advisors, most debt counselors tell you to do.
“Oh, pay off the highest rate credit card, and then take what you were paying on that one and apply it to the next credit card and the next credit card, and then pretty soon, all of these things you’ve paid off, allocate that towards your house mortgage against the principal of the mortgage, and you’ll be out of debt in 20 years instead of paying on it for 30 years. ” Well, that’s a good way, yeah, but it’s not the best way, and so first of all, people say, “Well, Doug, what’s your definition of out of debt?
” Now mine is different than most people’s, and you don’t have to have mine or adopt my definition, but I want you to understand it. See, I consider myself out of debt when I have enough assets, okay, over in this right hand pocket, on my balance sheet, so to speak. I have enough assets over here that any time, because they’re very liquid and safe, with an electronic funds transfer phone call, I can take those assets or a portion of them and pay off all my liabilities (hands clapping) that fast.
Then I am out of debt, see. I define out of debt as when I have enough assets, liquid and safe, that any time within an hour I could pay off all liabilities, and I’m out of debt, and I purposely do not pay the liabilities off.
I don’t take money from here and pay it off over here’cause it would actually cost me money because I understand how money works, and this is how banks and credit unions, it’s what makes the world go round, and so I can prove to you that, if you were to take what you would be sending against the mortgage principle if you’re sending an extra 500 or 1000 a month or you’re taking out a 15-year mortgage instead of a 30-year mortgage, I have an episode that shows this, in fact several on this channel, that if you were to take that extra principle payment that you’re hoping to pay off your 30-year mortgage in 20 years, maybe a biweekly payment plan or whatever, and usually you knock off about nine years off of a 30-year mortgage, hey, if you just socked that away into a compounding account tax free, and my favorite is a max-funded index universal life, you’ll have enough money here compounding tax free in this pocket that, 2 1/2 years sooner, you will totally pay off the 30-year mortgage.
You take the difference between a 15-year amortized mortgage payment and a 30-year amortized mortgage payment plus the tax savings (typewriter clicking) you will achieve (typewriter dinging) during the first 15 years of a 30-year mortgage, and you sock it away over here compounding tax free, you’ll have enough money to pay off that 30-year mortgage in 12 1/2 years instead of 15 years by using the 15-year mortgage method, and you’ll actually be using a bunch of Uncle Sam’s money instead of your own money ’cause you’re preserving your tax deductions by not killing them, paying it down, by giving extra principle against the mortgage. So you need to understand that, when you finally have enough money to get out of debt, I physically don’t do it. I don’t take the money out of this pocketand pay off my mortgages.
If I know I can do that any time, why would I do that if I’m earning double or triple the rate of return compounding tax free than the mortgage is costing. I would be costing myself money. I would be firing an employee that makes me 100%, 200% more than they cost me. So if you understand, or you need to understand, I’m gonna gift you a copy of my book at the end of this episode here, but the bestselling book in 2003 to 2005 was my second.
It was “Missed Fortune 101,” and so because of the popularity of this book, we went through a half a million copies, the Federal Reserve Bank of Chicago commissioned three The Federal Reserve Bank of Chicago report of their gurus to do an extremely intensive report to see if what I said in my book was truth or fiction, and so they went through all of this, and these three people finally issued their report, “The Tradeoff Between Mortgage Prepayments and Tax-deferred Retirement Savings. ” They thought I was using tax deferred.
I said, “No, I’m using totally tax free. ” So mine’s even better than what they came up with with their conclusions. Well, this is what they concluded, and they said, “If you are sending extra principal payments against your mortgage instead of putting it in a compounding account tax free, you’re making the wrong choice,” in their opinion.
They said, “That mortgage overpayment is a misallocation of funds. It’s actually slowing down your getting out of debt,” under the definition I’ve given you. They said, “If you would change that allocation, you would reap a substantial gain, and you would maintain your tax advantagesinstead of killing them,” and they said, “This was a rather conservative approach to optimizing your wealth.
This is the Federal Reserve Bank of Chicago,
verifying what I claimed in my book, and so this was a game changer for many people when they began to think differently. So I’ve always talked about whenever you borrow Borrowing to conserve. . . not to consume you should borrow to conserve, not to consume. The problem is most Americans who are strivers, they are living on the paycheck that they’re gonna get 90 days from now, and they go to an RV and boat show, and they borrow money for a depreciating asset.
You can see home equity lines of credit darting all over the lakes in the summertime in the form of boat and jet skis, people buying a depreciating asset with home equity, okay, with home equity loans or in the wintertime in the form of snowmobile. They’re buying depreciating assets. That means you’re borrowing to consume. That’s not smart. When you borrow, you borrow to conserve, to make money, to become your own banker, to do what banks and credit unions do. You conserve your assets. You maintain liquidity and keep it liquid, and then you’re gonna earn a rate of return double or triple the cost of the funds.
Even if I didn’t do that, I wanna maintain liquidity. I want access to money when I need it instead of having to borrow it back or sell the asset. So if I wasn’t making any money, I’d still keep it separated over herein this pocket with my assets versus my liabilities, but I have historically earned double, triple, quadruple, even five times the net cost of borrowing the money, and I’ll give you some examples of this.
So when we talk about these types of mentalities, there’s three kinds of people. Now, many people quote, “Well, there’s two kinds of people in the world, those who pay interest and those that earn interest. ” Oh, that sounds cute, but I go, “No, no, no, there’s actually a third kind of person, those that understand when it’s wise to pay interest in order to make more interest. ” This is what makes the world go round. This is banks and credit unions, insurance companies.
You can become your own banker. So the strivers are those who pay interest. They borrow to consume. Becoming your own bank The arrivers are those who earn interest, but the mega wealthy thrivers learn when it’s wise to pay interest to make more interest. So let’s talk about the philosophy behind this because so many times people think the smart thing to do is take their positive cash flow and send it against their mortgage.
“Here, Mr. Mortgage Banker, is an extra 500 bucks this month. Put it against my mortgage on my house or on my rental property,” if they have positive cash flow, thinking that’s the smartest thing to do. They’re saving themselves interest. They’re actually costing themselves, but they get into trouble.
They lack liquidity, and people learned this the hard way in 2008,and now they’re learning it again because, whenever you have a recession and real estate values go down like they did in 2008, if you have all your equity tied up ’cause you’ve been sending extra principal payments against it, and all of a sudden, your rental home (typewriter clicking) is vacant (typewriter dinging) and you’ve still gotta make a mortgage payment, the next mortgage payment is still due. It doesn’t matter how much you’ve paid against it. In fact, I’ve known some people who got windfalls of $100,000 and paid it against their mortgage, and then they lost their job the next month, and they were foreclosed on in 90 days.
The mortgage lender doesn’t care how much you’ve paid an extra principle. If you don’t make the mortgage payment for three months in a row, they’ll start foreclosure proceedings. It’s a lot better to have and not need than need and not have.
It’s a lot better to have access to your equity in your real estate, for example, than need it and not be able to get it because what happens is, when you go to refinance a piece of property, a lender is only going to loan you money based upon your ability to repay. See, if you lack the ability to repay, they’re gonna say, “Fat chance. ” They don’t care how much equity you have. Yeah, they’ll tie it up as collateral, but no, they loan you based on your ability to repay.
If you lack the ability to repay, they’ll say, “Sorry,” and then people lost their homes in foreclosure ’cause they had all this equity, and by the way, the lenders will foreclose on you faster if you have a lot of equity than if you owe more than it’s worth.If you owe more than, they’ll work with you all day long.
I can give you stories of this for years when this has happened during the ebbs and flows of the real estate market. So that happened in 2008, and it’s happening after post COVID-19 with commercial real estate.
Now, commercial real estate is probably 30 to 40% vacant because employers found out that about 50% of their employees worked as efficient or more efficiently from home. So they didn’t need brick and mortar offices for half of their employees, and so the demand for commercial real estate went down, and many of these landlords were collecting rent and paying it against the mortgage, and now they have to refinance, and it’s going to be at an interest rate double what it was because the US Treasury’s been raising the interest rates.
They can’t afford it, and they have all these vacancies. They lack the ability to repay a new loan at a higher interest rate, and so they come in, and they foreclose. This is why we have crises in the real estate industry because of lack of liquidity.
So that’s one of the big reasons why I keep my equity in my real estate properties liquid and safe in a max funded index universal life policy, but let’s get back to, again, out of debt. So many times I have to explain the difference between preferred and non-preferred interest expense. Preferred and non-preferred interest expense So let’s make sure you understand this. Let’s say you’re making $72,000, and this individual has 12,000 of interest they’re paying on whatever debt loans, but it’s non-deductible. It’s on depreciating assets, a car, a boat, or a jet ski or something. So they have 60,000 available before taxes, right?
This individual has 72,000,but they pay interest and borrowed against something like a home or a rental property where they can deduct the interest under section 163 of the Internal Revenue Code, and so they have 12,000 of interest. They still have the same 60,000, but what’s the difference on their tax return? This individual has to pay taxes still on the full 72,000.
This individual only has to pay taxes on 60,000 because they got to write off 12,000 of deductible interest. In a 33% bracket they save 4,000, 1/3 of that. This is real money. This isn’t paper money, and so when you understand the difference between preferred and non-preferred interest expense, preferred means deductible.
Then you know that you can borrow money at 6% in a 33% bracket, but it’s only cost you a net of four. If you borrow at 4. 5%, it’s a net cost of three. I have borrowed money at 3% in a 33% bracket as a net cost of two. Now, if you do the math in your head, my money over here compounding is earning eight, nine, 10 tax free using max funded index universal life.
If I’m earning nine and I’m only paying three, how much more is nine than three? Don’t say six. It’s three times. It’s 300% more. Why would I fire an employee or sell a widget machine that’s making me 300% more than they’re costing me? It costs me money to actually physically pay it off. Does that make sense? But I am out of debt any time I want by taking the money outta this pocket and paying it off, but that’s the difference in how people view this.