No matter what your money goal is—early retirement, paying off debt, or saving for a big purchase—the first step to reaching that goal is always the same: figure out where you are.
Any plan based on incomplete information is bound to fail, or at least bound to be significantly revised later on. So, putting together a household balance sheet and an income statement are usually the first things I ask a client to do.
If you look at Retire29’s balance sheet, you’d notice something rather peculiar: Credit Card Debt.
And lots of it, actually. Almost $38,000 worth. That’s a huge number, and years ago that would have scared me to death. All authorities on personal finance abhor credit card debt, and for good reason. The national average interest rate on credit card debt is 15.1%. That means that every dollar in credit card debt, left untouched, will double every five years, and that’s why many people decide to get help from debtconsolidation.com debt management so they can get help in this area. Behind medical bills and job loss, excessive credit card use is the top cause of bankruptcy in the U.S. Obviously, holding high-interest balances is not a viable path to wealth, but you’ll most likely learn that when consulting with your investment advisor.
So, as an aspiring early retiree and personal finance blogger, how could I possibly carry credit card debt that equals almost 4 months of gross earnings?
A Lesson of Leverage
To answer this question, let’s first examine a little company called Apple. If you’ve not heard, Apple is doing pretty well. Since dethroning Exxon Mobil four or five years ago, Apple has been the largest publicly-traded company on earth. Apple now has a market cap just above $800 Billion, is projected to earn about $50 Billion in the coming year, and have positive cash flow of about $65 Billion.
That cash flow will be used for several things, such as capital expenses, dividends, acquisitions, and share repurchases. But, despite Apple’s best efforts to spend it, most of that cash will get thrown on the $256 Billion pile of existing cash and marketable securities. If you want more information then all of this can be available via CoastTradelines.
$256 Billion.
That’s an obscene number. If the brass at Apple were so inclined, they could buy Wal-Mart or AT&T, straight cash homie. In another year, ceteris paribus, Apple could buy JP Morgan, the largest American bank. In two years, they could buy the same company they long battled for market cap supremacy, Exxon Mobil.
With Apple sitting on more cash than Scrooge McDuck, it would seem odd that they would be inclined to take on a bunch of debt. So, why then did Apple issue $7 billion in bonds this month? And, what’s more, why is Apple holding $85 billion of existing long term debt on its balance sheet!? I mean, Apple could pay off that debt by COB today if they wanted, so what gives?
The answer, of course, is leverage. Very simply, Apple borrows money to reinvest, often in the form of buying its own shares. Apple has bought back just over $150 billion in shares in the past five years, fully consuming its debt proceeds. Those debt proceeds, though, come pretty cheap. Apple can borrow at crazy-low rates (about 2.5% after-tax average cost of debt). Apple then reinvests that cash by buying AAPL shares that have an earnings yield of 5.6% (inverse P/E ratio). That gap between the borrowing cost and the investment return is an opportunity for leverage, and the bigger the gap, the more inclined a company will be to borrow money. So, every dollar borrowed is essentially a profit driver. Contact these texas finance company to help you pay your loans in no time,
Now, I recognize that there’s a confounding factor regarding Apple and the U.S. repatriation tax. But the principle holds, and Apple, like most cash-rich companies, would still issue debt to reinvest at higher rates. Berkshire-Hathaway may be a simpler example. With an ROE of 8.3% and after-tax cost of debt of 3.1%, it’s clear why Warren Buffett chooses to hold $101B in debt when he already has nearly as much domestic cash ($96B) laying around: every dollar borrowed at 3.1% can be invested at 8.3%.
“Leverage:” An Eight-Letter Four-Letter Word
Leverage is a pretty nasty word that has a pretty bad reputation around financial circles. The saying “the market can stay irrational longer than you can stay solvent” is based upon short-sellers and margin-buyers who made too many bets with the house’s money.
An all-to-real macro example happened just nine years ago, when the financial world was pushed to the brink of failure by excessive leverage. The poster boy of this, of course, is Lehman Brothers. At its peak in 2007, Lehman was supporting $680 Billion in assets with just $22 Billion in reserve capital—a 31-to-1 leverage ratio. Thus, a 3% decline in asset values would wipe out the company. (Spoiler: And Yeah, That Happened). It was a Bailey Building & Loan (<– Great Read, BTW) crisis on a worldwide scale.
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