The Value of Debt in Building Wealth summary

Imagine two families, the Nadas and the Radicals. In many ways, these clans are very similar. They have the same income, they invest in the same mutual funds. They even buy identical adorable row houses side by side. However, there’s one crucial difference: how they approach debt.

The Nadas are traditional. When they took out a home loan, they paid it all back as fast as possible. The Radicals took a different approach. They were fine with having debt. Instead of trying to eliminate it, they just paid the interest each month and invested the difference.

Now, when it comes time to retire, which family has a bigger stack of cash? Did you guess the Radicals? Despite conventional wisdom, they kept their debt and still managed to come out with more money. Maybe debt isn’t so bad after all.

The key message here is: Debt can be valuable – if it’s managed wisely.

When it comes to personal finance, debt is often vilified as an absolute negative. It’s common sense to avoid it if possible and pay it off quickly if you can’t. A recent survey of college students even found that a whopping 96 percent would prefer to have no debt at all. Yet, if debt is so bad, why do Fortune 500 companies regularly carry debts even when they have plenty of cash?

The truth is, for many companies, debt is a useful tool. Taking it on provides a financial cushion during emergencies or extra cash for when big opportunities arrive. So, what can debt do for you? Well, it can help you buy the things you absolutely need while freeing up your income for other uses, like savings.

Let’s take another look at our two families. To buy their homes, both took out loans of $300,000 with an interest rate of 3 percent. To pay this back quickly, each month the Nadas directed all their extra income, about $2,500, to paying the debt. In contrast, the Radicals only paid the interest, about $750 a month. They put the rest of their cash into savings and investments, with a modest yield of 6 percent.

Essentially, the Radicals kept their debt as a means to start saving early. This gave their money more time to compound over time. When retirement came, their nest egg had seriously grown. Meanwhile, the Nadas paid off their debt and got a later start on investing. Their savings didn’t have time to grow, and they ended up with a much smaller sum.

So, how can you apply this knowledge to your finances? We’ll look at that in the next blink.