Usually, one of the top financial priorities for us average people is to get out of debt. Whether that be student loans, car loans, or a mortgage, we want to pay them off as soon as possible to minimize the interest we pay. If we had the money, most of us would avoid debt altogether, but ironically, some of the richest people in the world also have the most debt in the world. By now, I’m sure all of you guys have heard about Elon’s plans to takeover twitter for $44 billion. And given that Elon’s net worth is currently hovering at about a quarter trillion dollars, it’s not impossible for him to just pay cash.
Yet, he’s planning on taking out quite a bit of debt. The current plan is to take out $13 billion in debt against Twitter, and $12.5 billion in debt against his Tesla stake. This means that he’s taking out a total of $25.5 billion in debt. Now, Elon may choose to pay more cash by the time the deal closes in order to minimize the risk of a margin call, but the root question still stands. Why even deal with debt and banks and interest payments when you don’t have to? This doesn’t just apply to large purchases Twitter either. Many billionaires will take out debt to buy homes, yachts, and private jets even though these purchases are a miniscule portion of their net worths.
Elon himself had 5 mortgages totaling $61 million before he decided to sell all his houses and move to Texas. So, why do billionaire voluntarily take out so much debt? MAXIMIZING RETURNS: One of the main reasons rich individuals prefer to take out debt instead of just paying cash is to maximize their returns. Given that they’re already rich, they’re well aware of how to produce significant returns on their money. Whether that be investing in commercial real estate, investing in stocks, or putting it all towards another business, these guys are experts at consistently beating the market.
Take Tesla for example. Since they went public in 2010, the stock has grown from $4.15 to $870 today. This comes out to an impressive 200x in 12 years or an annual rate of return of 54.585%. And that’s just the returns that Tesla has produced as a public company. Usually, the majority of the gains are made before companies go public. So, for it to make financial sense for Elon to sell his Tesla stock and let’s say buy Twitter, Twitter would have to reliably produce more than 54.585% per year. Now of course, Tesla isn’t going to grow at this rate forever, but I think you get the point.
Twitter would have to consistently beat the Tesla’s annual return for it to be a worthwhile investment. And the truth is, this is not very likely. First of all, it doesn’t seem like Elon is even buying Twitter to make money. It looks like he’s buying it for social reasons and to hopefully create change. So, while Twitter may naturally grow to $100 billion or something under Elon’s leadership, it’s not likely that it becomes like Facebook and reaches a trillion dollar market cap or anything. So, from Elon’s perspective, it makes sense to minimize the capital that he does tie up with Twitter given that it’s just a side project.
This same principle applies to much smaller purchases as well. For example, let’s go back to Elon’s $61 million mortgage, this took place in early 2019. At the time Tesla was just starting to recover from production hell and nearly going bankrupt. Shortly after Elon took out these mortgages, Tesla stock actually plummeted to just $36 per share in June of 2019. Now, imagine if Elon decided to sell $61 million worth of Tesla stock to pay for his properties instead of taking out a mortgage. Since this low in 2019, Tesla stock has grown nearly 23x meaning that the $61 million that he sold to buy his properties would now be worth $1.403 billion.
Even if we assume that the properties appreciated to $100 million, Elon would have left $1.3 billion on the table and that’s not even including future growth. This argument becomes even more relevant when you’re talking about depreciating assets like a private jet or a yacht. Such purchases are basically guaranteed to lose 70 to 80% of their value if you own them for a long period of time, so it makes no sense to pay for these purchases up front. The only reason you would pay for them upfront is for some sort of peace of mind, but in terms of returns, taking out debt is absolutely the way to go.
ILLIQUID: Aside from trying to maximize returns, one of the key reasons billionaires take out debt is because they have no choice. While they may have tens of billions or hundreds of billions on paper, the vast majority of this is simply paper wealth and completely illiquid. For example, over the past week, Elon sold $8.4 billion worth of Tesla stock to raise the cash that he committed to put up for Twitter. This sale itself caused Tesla stock to fall 12% in a single day. Imagine if Elon had to sell 5 times that amount to raise the full cash required to buy Tesla.
By the time he was done selling, Tesla would likely be down 60 to 70% if not more. Aside from plummeting the shares of his own company, he would have to deal with so much backlash from Tesla shareholders. Many Tesla shareholders are already pissed off that Elon sold Tesla stock to buy Twitter. To many of them, Twitter not only seems like unfavorable exchange, but it also seems like a unnecessary distraction. And they haven’t been scared to hold back their thoughts either. This one Twitter user posted “I don’t like that you sold shares, Elon.
Your money is not the last one out. I know people who got margin called today. Not cool.” This other user tweeted “I’m more disappointed he used it to buy Twitter. Genuine question, how many more years does Twitter have?” And all of this is just for a 12% sell off. Elon would literally be burned alive if he caused the stock to sell off 60 or 70%. And this is the same case with other founders as well. Bill Gates for example had to spend 25 years to cash out his Microsoft position. At least, these guys have the option to sell if they really want to. Many smaller billionaires don’t have a choice due to stock vesting.
Company owners usually don’t want high level executives or employees to sell off a bunch of stock if the company is going through a rough spot. These guys selling would just cause the stock to dip even further and leave the company off in a worse position. So, most companies implement a policy called stock vesting that prevents employees from selling their stock for a set period of time. Google and Apple, for instance, follow a 4 year vesting schedule. So, when we see headlines like Sundar Pichai made $281 million last year or Tim Cook made $265 million last year, just know that while this is technically true, they won’t actually have access to this money for years to come.
The only money they have access to instantly is their cash compensation which for Sundar Pichai is quote on quote only $650,000. So, while someone like Sundar or Tim can comfortably afford a $20 or $30 million mansion on paper, they don’t actually have the cash upfront which forces them to take a mortgage. MINIMIZING TAXES: While maximizing returns and liquidity are significant considerations, something that we haven’t even talked about is taxes. Now, a lot of people think that billionaires should be taxed way more, but really this wouldn’t even make a difference because these guys implement several clever strategies to minimize taxes, one of them being taking out debt.
While they’ll have to pay 3 or 5% interest on their loans, they can avoid much more significantly more in taxes. Currently, the highest tax bracket for long term capital gains is 20%. And if you live in California like many of these billionaires do, you’ll also have to deal with state income taxes. And to make things worse, California doesn’t discern between capital gains and regular income, so you’ll have to pay the full 13.3% to California. This means that your total tax load comes out to 33.3%. Now, I’m not looking to argue whether this is a fair amount or not, but this strongly discourages billionaires from selling their stock.
Going back to Elon’s $61 million mortgage, we already calculated that Elon would’ve left $1.3 billion on the table if he paid for these properties in cash, but this doesn’t include taxes. If we tack on a 33.3% tax, we’ll see that Elon would’ve had to sell $91.5 million worth of stock to pay for these properties in cash. Again, given that Tesla stock has grown 23x since Elon bought these properties, that $91.5 million is worth $2.1 billion today meaning that Elon would’ve straight up left $2 billion on the table. And looking forward, if Tesla grows another 5x within the next 10 to 20 years, that $91.5 million purchase which was a miniscule portion of Elon’s wealth even in 2019 would be worth $10 billion.
So, when you have exponential growth working in your favor, you want to be as invested as possible and you definitely don’t want to bleed any money to the IRS. INFLATE AWAY DEBT: While everything we’ve covered so far are great reasons to take out debt, even if none of those reasons applied, the rich will still take out debt for one reason and that reason is inflation. Over the past year, for everyday Americans inflation has been devastating given rapidly rising everyday expenses. But, for people who are holding debt, it’s actually rather beneficial. Here’s the thing, the amount of money you owe is not going to go up because of inflation.
But, the amount of money you earn will go up. Now, unfortunately, wages don’t always keep up with inflation especially in times of high inflation. And while this strategy works best if your income scales perfectly with inflation, it’s also applicable even if your income doesn’t quite keep up especially over the long term. For example, a dollar today is only worth half as much as a dollar from 1992. Now, let’s assume that you got a 30 year fixed rate mortgage in 1992, for $200,000. At first, maybe half of your net income goes towards your mortgage payment. After 30 years though, let’s say your income doubles thanks to inflation and promotions.
At this point, the same mortgage payment only accounts for a quarter of your net income. And that’s with relatively conservative growth numbers. What if your income actually grows 5 or 10x in those 30 years? That mortgage would become a miniscule expense by the time you pay it off. And this is especially applicable if you have a business in a high growth area like many billionaires. It’s not just billionaires using this strategy either. This is one of the key strategies governments rely on to reduce their debt load over the long term. They just inflate it away.
Now, I would argue that governments have taken this to an unacceptable extreme but that’s a wholenother conversation. All you need to know is that making a debt payment in the future should be easier than it is right now, so rich individuals prefer to leverage this to their advantage. TIME TO GO IN DEBT?: Hearing all of these advantages, it’s likely that many of you guys are wondering if this strategy would work for you. And, unfortunately, if you have to ask that question, the answer is probably no. The best course of action for the average person is to pay off student loans, car loans, and credit card loans as fast as possible or not take take out these loans in the first place.
There is one area in which the average person could leverage this strategy, but it requires that they’re disciplined and willing to invest regularly. Instead of taking out a 10 or 15 year mortgage, it would be smarter to take out a 30 year mortgage, and invest the monthly savings into the S&P 500. But, if you know that you won’t be that disciplined at that you’ll end up spending this money instead investing it, it’s better to just get the shorter mortgage and pay off the debt. And given that the average person falls into this category, sticking to Dave Ramsey’s advice is likely the best course of action. But that why it makes sense for many billionaires to take out debt instead of paying cash.
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