Debt's Downside

The primary issue with how many American families manage debt is that they often borrow to purchase items beyond their financial reach. Many of these purchases lose value over time, causing an even greater financial setback.

For instance, instead of opting for a reliable used car priced at $15,000 in cash, most families will choose a newer model costing $30,000 or more, financing the difference to make it seem affordable. Using a calculator, if you make a 10% down payment and finance the balance over five years at an 8% interest rate, the monthly payment would be approximately $550.

To illustrate the effect on your financial standing after one year: you would have contributed $6,600 in principal and interest (excluding insurance and other costs). Your initial balance of $27,000 (the car’s price minus the down payment) would drop to $22,425.

If the car's value remained at $30,000, your equity would total $7,575 after a year of payments, resulting in a loss of $2,025. However, since new cars typically depreciate by about 20% in the first year, it would likely be worth around $24,000 instead.

After accounting for your payments, your equity would only be $1,575—less than your initial down payment. This results in a staggering loss of $8,025 in just one year on a cash investment of $3,000 (the down payment), equating to a negative return of 267%.

Conversely, a family that pays cash for a $15,000 used car would face a mere 15% depreciation, translating to a loss of about $2,250 in the first year. Clearly, leveraging debt to enhance spending accelerates financial loss. Would you rather incur a 15% loss by paying cash for a used vehicle or a 267% loss in the first year through debt for a new one? The conclusion is evident: using debt to acquire depreciating assets hastens wealth depletion.

Debt's Upside

If borrowing to purchase depreciating assets amplifies financial loss, the opposite holds true as well. When used judiciously, debt can expedite wealth growth, particularly when acquiring appreciating assets that generate cash flow.

For instance, leveraging debt to purchase a single-family rental property can boost annual returns from around 10% to 20% or higher. While paying cash for a rental home (as advised by financial guru Dave Ramsey) can yield better cash flow, it doesn’t facilitate wealth acceleration.

Assuming a purchase price of $400,000, a 5% cash return and 5% appreciation would yield a total return of 10%. This equates to $20,000 annually from cash flow (after expenses) and another $20,000 from appreciation, totaling a $40,000 return on investment.

In contrast, an investor using debt (as suggested by Robert Kiyosaki and others) purchases the same property with a 25% down payment. While their cash flow may be diminished by mortgage payments, they still receive all the appreciation. The $400,000 house appreciates by $20,000 in the first year, translating to a 20% return based solely on their $100,000 down payment ($20,000 / $100,000).

This simple example illustrates how prudent debt usage can enhance returns.

Critical Analysis

The challenge faced by many middle-class families in America is their tendency to use debt for unaffordable purchases, leading to accelerated wealth loss. The desire to appear affluent by driving luxury vehicles or acquiring other costly items hampers true financial growth.

In contrast, those with a deeper understanding of finances leverage debt to acquire wealth-generating assets, resulting in accelerated returns. Beginners can achieve around 8% returns by investing in low-cost index funds, which is a sound starting point. However, for those aspiring to substantial wealth during their prime years, returns above 20% are essential.

By judiciously employing debt to invest in real estate and select other assets, individuals can achieve these higher returns without incurring excessive risk. While this approach may require more effort than simply investing in index funds, it demands significantly less work than running a business, including online ventures.

Once you amass sufficient wealth, you can purchase a luxury vehicle and let your assets cover the cost. This is the strategy employed by the affluent, and it's a pathway for the middle class to transition from financial struggle to wealth accumulation.

Best wishes on your journey, and feel free to reach out if you need assistance!