Rare is the decade where a capitalist society doesn’t experience an economic slowdown. Call it a soft landing, recession or depression, the results are the same with varying degrees. Economic slowdowns and declines are inevitable under capitalism.
Expansions are born from the depths of the previous economic decline. Inflation tends to be low and unemployment high. Pent up demand is waiting for an influx of goods and services to satiate desires. As businesses whittle down inventory, the recession eases. A glimmer of increased demand begins the cycle all over. Employment increases to meet demand. Eventually wages climb as the labor market tightens.
Increasing productivity means even a slowdown in growth can start unemployment ratcheting higher; no actual recession needed to send hearts aflutter. Sometimes the economy slows sharply as in the early 1980s and 2008. Most recessions since World War II have been mild, with GDP declining 2% or less. The 2008 recession lasted 18 months and it felt like the world would end. In reality, GDP declined 5.1%. The 2001 recession, in comparison, lasted 8 months with a .3% decline in GDP.
The last time economic activity declined more than 10% was in the waning days of WWII. Reduced military spending caused the GDP to dip 12.7%. Unemployment didn’t climb much in 1945 as the U.S started the switch back to a peacetime economy. Before WWII, recessions more often than not exceeded 10%. Economic downturns were far sharper in those days and lasted longer. Still, unemployment can climb quickly to double digits or nearly so. When pink slips start flying they come fast and furious.
The longest economic expansion on record started March 1991 and continued for a full 10 years, ending March 2001. The current economic expansion started June 2009. We are nearing another record long period of economic nirvana.
Long periods of economic bliss lull people into a false sense of security. Debt grows larger as a percent of income as households are more confident.
Inflation is creeping higher. The Fed is slowing increasing interest rates to reflect a normalization of interest rates after the deep 2008 recession. Unemployment is near record lows and employment numbers are off the scale! Warning signs are beginning to show as consumers are reaching their credit limit, ending the buying binge. The cycle is nearing the point of renewal.
Renewal is painful if you’re unprepared.
Overproduction and debt usually play a role in most recessions. U.S. production isn’t as out of touch with demand as world production, most notably in China and Germany. However, by previous economic standards, the economy isn’t stressed enough to trigger a downturn of any size. Things look really good right now. But. . .
Tariffs are the wildcard. Tariffs are designed to slow the economy, regardless the claims of politicians. Business is well aware of the seriousness of the current rush to impose tariffs. Tariffs also push inflation higher.
Signs are showing in the EU, China and other countries. The U.S. so far is humming like a well oiled machine. If tariffs continue ratcheting higher the U.S. will eventually stumble, too.
Tariffs are taking on a different flavor this time around. (This time isn’t different, however.) In 1929, tariffs were adjusted across the board. Retaliatory tariffs were levied nation against nation around the world. Today we see the U.S. imposing tariffs and the target nation strikes back with narrowly focused tariffs against the U.S. only. Without the U.S. a vacuum has formed. Most nations are building new economic alliances without the U.S.
There is no doubt tariffs will cause pain around the world. The U.S. already discovered how the new world order of tariffs will be played out. Harley-Davidson, an iconic American company, is moving some production to Europe to avoid tariffs. If the intension of the tariffs was to bring jobs back home, it’s having the opposite effect! Time will tell how this new world order plays out.
The world isn’t going to end! You can drop the end of the world stuff right now. However, there is economic pain coming. The exact cause is not yet known. The possibilities discussed about are strong possibilities. Then again, it could be something totally out of left field, like Lehman Brothers in 2008. You never know.
What we do know is that this cycle is long in the tooth and it’s time to prepare for the inevitable slowdown in economic activity, even if it doesn’t culminate in a full-blown recession. Unemployment will climb someday and probably sooner than most people expect. If tariffs bite as they did in the past, we could be within a year of slower economic growth.
Since my crystal ball isn’t any clearer than yours, all I can do is provide good advice that works in good times and bad. Wealthy people have certain habits you need to acquire ASAP!
For several years now I’ve warned clients to reduce, or even eliminate, debt. The 2008 recession only hurt if you were saddled with debt payments. Without debt, 2008 was a minor inconvenience. Debt is a common recession culprit. Don’t be part of the problem! Your insistence you are responsible with debt crumbles when unemployment makes an appearance in your household, your income properties are vacant or the tenants refuse to pay, or your business or side hustle no longer provides the cash needed. I hear the “responsible with debt” mantra often. I’ve also been around long enough to watch said clients have their home repossessed.
Debt is the most important issue to address. If you are deep in debt, there are steps you can take to reduce liabilities fast. Normal pay down of debt may not be fast enough to give you a margin of safety before the recession strikes. Prices are still high. Selling assets at a high is better than liquidating later at any price, or worse, giving assets back to the bank.
I firmly believe you should NEVER have debt on a vehicle. EVER! If you need a car loan you can’t afford the vehicle. If you bought real estate the last few years, consider reducing debt by selling highly appreciated properties. I know real estate never declines in value (egads!), but selling a property or two to eliminate debt obligations allows you to sleep better in any economic environment.
Here is the last word on debt; I promise. All consumer debt must go! No credit card debt! Period. Now is the best time in a generation to reduce debt. Your assets are worth more now than in decades. Take advantage of your great fortune.
Rainy Day Fund
I’m now going to share advice I give to all clients near, entering or in retirement.
Retirees need to keep ~ two years of spending in a liquid account (money market (I like Vanguard), Discover Savings, Capital One 360 or T-bills). If the market keeps rallying, take living expenses from your index funds. If the market declines, use the liquid funds to live on. Divert capital gains and dividend distributions to the liquid account instead of reinvesting. This gives you a margin of safety of several years before you’d have to either reduce your lifestyle or sell index funds in a down market to cover living expenses.
For those not in—or near—retirement, the same philosophy applies. Rather than two years of living expenses in liquid funds, you may wish to only keep one. In a perfect world you would have Roth IRAs so there would be no tax consequences of moving some index fund money to the money market account.
Facts and circumstances will determine the correct level for you and the accounts you increase liquidity in. Having liquid funds to cover living expenses is a powerful tool to weather any economic storm. The only issues not covered are outliers. An uninsured medical emergency can throw any plan awry. Disability is another potential problem. It’s impossible to cover all possibilities. Having a cushion, a margin of safety, stacks the deck in your favor.
A Hard Man to Break
I don’t predict the economy or the stock market. Far better than me try and fail miserably. This isn’t about market timing! This is about structuring your finances in an appropriate way.
Debt is the worst cancer. Debt is a crisis, especially this late in the business cycle unless you think this time is different. (It’s not!) Low debt levels are always the better path. Virtually every wealthy person you meet says the same thing: leverage (debt) bites you in the end.
Keep adding to your retirement accounts. This is not the time to break a good habit. If you don’t have a lot of non-qualified (non-retirement) money you may have to keep some IRA or other retirement money liquid. If your finances are not affected, no problem. If you do face financial stress you at least have liquid funds available (even if a tax penalty applies) to cover living expenses for an extended period of time without the bank knocking at the door.
Opportunities are created in recessions. The U.S. has had 49 economic downturns in its history. We get to celebrate the grand ol’ 50th with the next recession. Limited debt and liquid funds for spending needs allows you to keep your money invested for the next inevitable economic expansion. The winners of the last recession were the ones who stood pat or even bought while the market was down.
Things have to get really bad for people without debt to suffer. A liquid nest egg coupled with no debt requires a complete system failure before you feel any real pain. And if the system does fail there is nowhere to hide so it doesn’t pay to prepare for it. It’s lights out.
More Wealth Building Resources
Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?
Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.
QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. Quickbooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.
A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.
Amazon is a good way to control costs by comparison shopping. The cost of a product includes travel to the store. When you start a shopping trip to Amazon here it also supports this blog. Thank you.
Instant gratification is the hallmark of a good economy according to the government wonks and marketers. It is also the hallmark of the impoverished souls forced to work forever in a soulless job to cover the debt payments.
Watching clients for decades has made it clear there are only a few golden rules to wealthy. Automatic investing is one; deferred gratification is the other. Deferred gratification is what funds the investment account so I think deferred gratification is by far the more powerful of the two traits.
Instant gratification is sometimes hard to see. Today I will point out all the signs you are satiating your lusts a bit too quickly for your own good. By recognizing your overzealous spending habits you can delay gratification to your benefit. You give up nothing, but gain plenty of freedom, less (or no) debt and financial independence. It is a stress-free way to conduct life.
Signs You Are Not Delaying Gratification
Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, said in a recent CNBC interview, he believed in “deferred gratification”. Munger is 93 years old. And he still believes the best way to live life is by deferring gratification. Does he know something most of us miss? Perhaps the secret to wealth AND happiness is delaying gratification, if not outright ignoring certain gratification permanently.
Even frugal people are guilty of instant gratification. The most obvious tell-tale sign someone is not deferring gratification is debt. Spending more than you earn is a direct result of satisfying lusts without proper thought. Every pretty trinket draws your credit card from its nest without regard for consequences.
Then we have the so-called “good debt”. Try to run that one past Dave Ramsey. Common practice says business and mortgage debt are good debts, along with student loans. Wrong! Debt is the acid which destroys the vessel which holds it.
Before anyone goes and accuses the friendly accountant writing these words of hypocrisy, I confess I have a small loan on my personal residence. Let me give you the excuse first. I have the cash to pay it off and the interest rate is so low my investments earn more. Now let me tell you a story about why my theory is 100% wrong.
Back in 1978 inflation was rocketing higher. Banks convinced farmers borrowing more money was wise because interest rates were lower than inflation and commodities were moving higher. (Interest rates would soon catch up to reality.) It’s the same argument I make today with my home. Inflation is 3% and my mortgage rate is 2.375%. Back then inflation was 8% and interest rates 7.5%. Same BS story when you think about it. Heck, dividend yields were darn near as high as the interest rates around 1980.
My family bought the line. We were dumb farmers and dumb farmers go broke. Interest rates moved higher, the economy stalled and commodity prices collapsed. The family farm went into bankruptcy in 1982. Here is why.
No matter how bad things get you can always cut costs. You can grow your own food, sew your own clothes, turn down the heat and eliminate any spending not 100% necessary. You can live on almost no money if you really have to. The one thing you can’t cut the cost of is debt. Those payments are due each month and there is no way to reduce the cost without coming up with the cash to pay the debt in full. And the money to pay the debt off in full has been spent long ago on something you don’t care much about anymore.
Student Loans and Mortgages are Required
No they are not! I understand most people starting out can’t pay cash for a home. I get it. However, once a home is secured, mortgage retirement must be a priority. No one ever lost their home to the bank without a mortgage. It sounds like a stupid comment, but I keep making it at the office and people keep ignoring the advice and losing their homes. Trust me, it’s not a crime to retire your mortgage. And don’t get me started on the tax deduction argument. I do not have to explain giving the bank $10,000 in interest to get $3,000 back from the IRS is industrial strength stupid.
Student loans are the other popular debt today. Gotta get a student loan so ya can get smart and earn mo money. It’s just another error in judgment and refusal to heed Munger’s advice: defer gratification. Spend today to pay it back later with interest. Dumb.
The first test of going to college is getting there. Putting it on the credit card is not earning the right to attend. Scholarships would qualify.
Debt as a Cash Management Tool
By now you must think I am cold and callus. I get it. My attitude can rub some wrong. But I have watched for too many decades client after client suffering the consequences of not following this simple advice, to live debt-free.
But debt can be a tool. Short-term use of debt in business frequently makes sense. If the money is there but using it would cost more than borrowing, then debt is the proper course as long as you retire the debt in short order.
Just like a mortgage, cash management debt is acceptable if a shoulder is put into killing the debt as quickly as possible. The same applies to student loans. If a modest amount of debt is needed to finish a degree it is usually the proper course to do so. But if you have no scholarships or personal cash to fund the bulk of your education expense you are engaged in instant gratification at the future’s expense. Student loans lingering five or ten years later is a problem. If you have to change your lifestyle to deal with the debt you might need to rethink the reason behind acquiring the debt.
Don’t get suckered into the leverage argument either. Of course leverage increases the rate of return on an investment. It also magnifies the losses when thing head south.
Defer Without Pain
Deferred gratification only hurts if you let it. Munger is 93 and still talks about delaying gratification for something he will never live long enough to see. That is the mindset that made him rich, mentally well adjusted, happy, and never feeling like he missed out on anything. Munger has enough money to buy anything he wants. But as Buffett said, more homes would not make him happier. In fact, it probably would make him less happy.
The only path to wealth is deferred gratification. If you buy everything you want when you first want it you will be broke. And miserable! Use an old trick when you see something you want. Sleep on it for three days. If you still want the item you at least can rest assured you want it enough to use it for an extended period of time.
Practice poverty, as Cato and Seneca recommend. It’s not that bad. Spending every penny you earn is the part that causes lasting pain and loss of freedom. You will find owning less stuff an important part of freedom. It’s not only the debt and lost opportunity cost of money you could have invested, it’s also the burden of storing, using, protecting and managing all the stuff you have. The weight of buying every trinket the moment you see it is quite a stressful lifestyle.
And you will not miss the stuff you don’t buy! All the toys and electronics are a distraction at best; a distraction from the truly awesome things life offers. When you buy something you also feel an obligation to use the item at least for a while to justify the purchase. Instant gratification is a harsh mistress. She demands your soul long after the transaction is finished.
Happiness is in less. The only time more is better is when basic human needs are unfulfilled. You need a minimum amount of quality food and water, clothing to keep warm and shelter. The shelter does not need any fanciness; the clothing can be old and plain to meet your basic needs. If you are not happy at this point more stuff will not fill the void as marketers would have you believe. After the basics, additional stuff is a job weighing you down. Only you can decide how much of a load you plan on carrying around for decades.
Charlie Munger still preaches deferred gratification for the country and himself. He refuses to buy just because he can. He knows buying will not make him happy or feel better. Munger enjoys good books daily and prefers a good deal over crazy spending even though it would make no difference to his wealth at this stage of the game.
I hope CNBC keeps the article up for a long time. You can read it here if they do. Munger’s comments were about the nation preserving natural gas resources while waiting for other parts of the world to exhaust their supply. His advice will not come full circle in his lifetime. It does not matter to him. Doing the right thing does.
This is an important topic people must hear. Please share, like and comment. Your small effort could make a difference in our modern world.
Low interest rates have raised concerns if it is proper to pay off debt early. The good news is there are ways to determine if you should pay down debt, including the home mortgage, or invest funds to accelerate net worth building. Low interest credit card teaser rates and equity lines of credit add another dimension to the ever evolving world of personal finance. There are two factors to consider when balancing between reducing debt or increasing investments: the return on the investments over the cost of capital and the risk factor.
Personal finance can learn a thing or two from corporate finance when it comes to debt and investment. Just like a business, when a household decides to pay down debt there is a tradeoff. Accelerating debt reduction takes money from other areas, mostly spending or investment, but also reduces risks associated with debt servicing. In this post I will assume you have reduced your spending to a reasonable level and the trade-offs are between debt retirement and investment only.
Think like a Wealthy Accountant
Business owners understand investing capital. To survive, businesses must invest capital to preserve and grow future revenue and profits. Without investment it is only a matter of time before the business stalls followed by decline. At the same time a business invests in its future it also has to keep an eye on debt levels. Many small businesses choose to operate with no debt, funding investment internally; many households do the same. However, a home purchase usually is accompanied by a mortgage. The question now revolves around paying the mortgage off faster or investing the extra funds into investments generating a better return than the mortgage interest rate.
Business schools teach that wealth is created when companies invest capital with a greater return than the cost of capital. This is the right place to start when reviewing personal finances. Low interest rates make it easier to find investments throwing off returns greater than the mortgage interest rate. Currently the S&P 500 yields just over 2%. Alternative investments like Lending Club reasonably return 8-12%. Many corporate bonds throw a higher interest rate than the lowest rate mortgages as long as you are willing to assume risk.
Retirement accounts have significant tax benefits shifting decisions toward investing over debt reduction. For example, if you are in the 25% tax bracket and contribute to a traditional (deductible) retirement account you are guaranteed an upfront 25% advantage from tax savings alone. Any employer matching increases the advantage of investing over addition debt reduction.
It all looks good on paper. Since many investments have a higher return than mortgage debt, it makes sense to be mortgaged to the hilt (leveraged) to maximize wealth building. But that assumes your investments are 100% risk free. Your mortgage is guaranteed to come due or you lose your home and any accumulated equity. Investments do not afford such guarantees. Sure, government bonds and certain bank deposits are guaranteed, but at rates well below the interest rates of any mortgage.
Credit cards now have teaser rates as low as 2%. Clients sometimes want my blessing to borrow from their credit card interest free for a year with a 2% fee, in effect a 2% annual interest rate.* The idea has merit because, once again, it looks good on paper. Unfortunately, the loan comes due in a year regardless and if you don’t pay in full the interest rate goes through the roof. Therefore I never encourage this hyper-risky activity.
Back to the mortgage. People with great credit scores can borrow against their home for around 3%. The broad stock market averages around 7% per year over long periods of time. The current 2% dividend yield is the only real cash flow.** The only way to service debt with money invested in an index fund is from another source. I hate the idea. If the other source dries up you are screwed if the index fund is also down. The dividend yield is not guaranteed, though reasonably stable with an upward bias, is not enough to make full debt service payments. It is safer to not borrow, instead taking the debt service payments you would have made from the other source of income and dollar cost averaging into the index fund over time.
Now for an example of what could work. Alternative investments like Lending Club have significantly higher rates of return on a broad basket of notes owned. A good mix of medium and lower quality notes on the Lending Club or Prosper platforms have high default rates, but with an investment spread among hundreds or thousands of notes the risk is mitigated. I have an account at Prosper and Lending Club. Results have remained steady at around 8% for Prosper and 10-12% for Lending Club.***
Logic would dictate you should max out every lending facility you have and drop it into Lending Club. Except it would be insanity! Yes, I understand Lending Club has better cash flow from loan payments to fund debt servicing without selling notes owned, but there is no guarantee past results will continue. Even wealthy people should only consider micro lending for a small percentage of their portfolio. Borrowing money to invest in a risky business like Lending Club is ill advised. On paper it looks great. However, even a small hiccup could destroy a massive portion of your wealth, even wipe you out. No accountant worth their salt would ever encourage such reckless behavior.
Balancing Act and the Sleep at Night Factor
I will now share how I handle the issue of debt reduction and investing personally. I use several credit cards for a variety of businesses, paying them in full each month.**** The only interest I pay is on my mortgage. I have a farm and farmers get really good deals from the government. My mortgage is from Farm Credit at 2.125 percent. At such a low rate I have struggled with paying the thing off. If, I argue with myself, interest rates ever go up I will have a guaranteed way to make more money than the mortgage interest. It is a big ‘if’. I thought interest rates would be higher by now so my theory was shot down already.
A few years ago my mortgage was around $300,000; it is now under $130,000. I will retire the mortgage in the next 18-24 months regardless what the markets or interest rates do. The mortgage balance was so high a few years back because I used a questionable strategy I alluded to above: I borrowed and invested the money in an index fund. The market treated me well, but there was no guarantee and I took a big (and unwarranted) risk. My income level easily handled the mortgage payment without selling an investment. Currently I max out my retirement accounts and then funnel the remaining free cash flow to mortgage reduction. Small amounts are sometimes diverted to interesting investments, but the goal is now to be 100% debt-free.
There is a “sleep at night” factor involved. How much money is enough? The stunt I pulled was for more money only, a chump’s game. It worked out, but it also could have set me back.
I think eliminating all debt except the mortgage has got to be a top priority in everyone’s life. If you can’t afford an auto without a loan, you can’t afford that auto. Credit card debt is unacceptable ever! Credit cards are a tool to run your business and personal life easier, not a lending tool. Every credit card I have is set to auto-pay the entire balance on the due date. Credit cards have great rewards programs which can benefit users as long as you never carry a balance.
Student loans scare the shit out of me. I never had a student loan in my life and refused to sign one for my daughter going to school. First off, they are hard to discharge if the crap hits the fan in your life. Student loans follow you around like the plague. My opinion is student loans are a priority to eliminate. Self-fund your education instead. The first test of college is getting there. If you don’t have the money, get a scholarship. If you can’t get a scholarship you are not ready for college.
I am more lenient on mortgages. I understand owning a home without a mortgage is difficult in the beginning. However, your loan to value should be reduced to under 50%. That means if you have a $500,000 home, the mortgage should be less than $250,000. At some point you want a plan to retire even this vestige of debt.
A Good Plan
Here is what I consider a good plan balancing debt reduction and investment.
- High interest debt goes first before funding anything else. Credit cards and payday loans fall into this group; student loans and mortgages generally do not.
- If you have bad credit and have a high interest auto loan, sell the auto and find alternative transportation or a vehicle you can afford with cash.
- Now you can fund your retirement accounts. The minimum is the level your employer matches. Once you reach that level it is time to bifurcate your finances between further investments and mortgage debt reduction. If you only have a mortgage or maybe a student loan you can now ramp up investment into your retirement plan. A good goal might include maxing your retirement plans before increasing payments toward debt reduction due to the heavy tax gains retirement plans offer.
- Once the retirement plan is filled each year it is time to set aside money in non-qualified investments (non-retirement accounts) and accelerate mortgage reduction until the mortgage is retired.
The final goal is to be debt-free most of the time. A short-term mortgage to move to a new home might be wiser than selling an investment. Maximizing wealth using leverage is certain to end in tears. It looks good on paper and some accountants even promote the idea of leverage to spur wealth building. The Wealthy Accountant is not one of them. Debt is a useful tool when used sparingly. Most people who are rich have either no debt or modest levels of debt.
I could probably earn more than a 2.125% return on my invested capital; I am still paying off the mortgage. My reason is simple. Without any bills to pay I am free to go and do what I want when I want without worry. And nothing beats a good night of sleep.
* Yes, I understand the annual interest rate is higher than 2% in the example due to payments required during the year. Just play with me. It is an example to highlight how the process works and if it is a viable personal finance choice.
** Don’t even start with me on selling options to generate an income stream. I’ll slap you silly.
*** I started withdrawing funds from Prosper a few years ago. When Lending Club had some legal issues a year ago I started withdrawing funds there, too. New notes purchased tend to spike your rate of return. With both Prosper and Lending Club I noticed a large decline in my return once new investments stopped. For example, Lending Club was always yielding over 12% when I kept reinvesting, but dropped to just over 10% when I started to withdraw funds. The rate is still falling and my guess is it will end around 8%, where Prosper is. Something investors holding Lending Club and similar investments need to consider.
**** I have a post in the queue on how to use credit cards correctly, paying no interest and receiving a large amount of tax-free income. I am waiting for final approval of a credit card aggregator so I can link the credit cards with the greatest tax-free money attached.