Talking to Tom Anderson About ‘The Value of Debt in Building Wealth’

Let’s answer that question about whether we should save X times our income or X times our expenses.

Regular Billfold readers will know that I recently read Thomas J. Anderson’s The Value of Debt in Building Wealth and got very, very excited about applying the book’s ideas to my own finances.

‘The Value of Debt in Building Wealth’ Could Change Your Financial Life

As a quick reminder: despite the title, the book isn’t about going out and getting into a bunch of debt. It’s about figuring out where your money will get you the most value. At certain periods in your life, that means building liquidity in a savings account; at other periods in your life, it might mean making the minimum payment on a mortgage so you can put more money into investments that are offering a higher return than the cost of your debt. (That’s where “the value of debt” comes in.)

I’m not at the mortgage stage yet, but that doesn’t mean I can’t spend the next several years—or the rest of my life—using the cash I have to build as much wealth as possible. (Wealth, in this case, being relative. My current financial goal is to have 15 times my monthly pre-tax income saved, which might take me five years.)

I got to talk to Anderson yesterday about The Value of Debt in Building Wealth, and ask him some specific questions about income vs. expenses, how to deal with a savings goal that recedes as you get closer to it, and if the concepts in his book apply differently to freelancers and small business owners.

The following is an edited and condensed version of our conversation.

ND: Let’s start with one of the biggest questions asked by Billfold readers. Why do you recommend saving X times our income, and not X times our expenses—especially if we’re frugal and our expenses are significantly lower than our income?

TA: Companies have income statements, balance sheets, and cash flow statements. The three are directly interconnected, so anybody who ever makes a financial model looks at how income, balance sheets, and cash flow are related. That concept kind of comes in to your other question about freelancing as well, because freelancers and small business owners often have a material difference between their income and their cash flow.

The reason I start with income is because I think that your expenses should be a function of your income. You have a debt to your future self, so your first expense needs to be to save. That’s required. The first person you need to pay is yourself, by building up that liquidity and that savings net.

So, starting with your income, the first thing you need to do is put money aside, and then look at how much you have to spend. Expenses can vary, as people live a lot of different lifestyles, but the math [in the book] works very elegantly if you think of your money as an income statement relating to a balance sheet.

If I started with somebody’s expenses, too many variables start to come in.

I absolutely agree. We don’t know what our expenses will be in the near future, but we also don’t know what our income will be necessarily—so I wanted to ask about the idea that, as we earn more, we fall behind this goal of “five times our monthly income, ten times our monthly income.” The more we earn, the less we have saved towards that goal. How do we recalculate our goals as our income continues to grow?

What you described as the “time horizon of wealth,” this thing that recedes as you get closer to it, is intentional and it is by design.

The Time Horizon of Wealth Is Super Long

By having your savings be a function of income, even as your income changes, makes the book’s ideas more evergreen with respect to concepts like inflation. We’ve had a lot of inflation, from the 1970s to today. There are two types of inflation: inflation of the goods and services we consume, which is bad inflation, because that means our purchasing power goes down; and good inflation, where I’m getting a raise and my income goes up by 10 percent and the cost of goods go up by 2 percent, and my purchasing power grows.

As our purchasing power grows, we typically like to consume more things. By holding the savings percentages constant, as our income changes, I’m basically saying “That’s awesome! Every time you get a raise, I want you to go spend 85 cents of every dollar! Go buy stuff that you want, or do the things you want to do!” But you have to keep saving that 15 percent.

It makes this system mathematically more robust, even as your personal life changes and as inflation changes and as the world changes around you.

Let’s use a specific example, though. As a freelancer, my income has the capacity to grow tremendously in a year. In the past couple of years, I’ve increased my income by $20K each year, which is great for me. But let’s say that I’m reading your book and I’m reading the idea that I’m supposed to have 15 times my monthly income saved so I can have enough liquidity to make a major purchase like a house or a wedding.

But if my income jumps by $20K in a year, I am suddenly much further behind on the “15 times my monthly income” goal. Does that mean I put off this major life event until I hit that goal? The practical side of it could be confusing to people who want to follow the plan very strictly. What would you advise for that kind of situation?

My income has always been varied throughout my life. People who are on commission or have variable incomes tend to both over- and underestimate their incomes. I want people to take a conservative approach to income tracking.

Let’s say your base assumption is that your income is $60K, and it happens to come in at $80K one year. Rather than reapply all of the math to the $80K range, you can say “Well, that was kind of lucky. Next year I think it’ll be closer to $60K.” So, if you hold your base income number at $60K until it becomes clear you need to reevaluate, the rest of the savings numbers don’t change.

People in real estate, for example, often have one or two good years and those income bumps can screw up the math. So I think you want to use a conservative income number, and if you’re consistently finding that your income is coming down on the higher end of that scale, you can reassess and use a higher base number.

You could also argue that since it’s going to take you probably five years to go from the Independence level to the Freedom level anyway— mathematically, if you’re saving 20 percent of your income every year—in five years you could have a really nice average of what you’re making instead of changing your goal every year based on what you’re actually bringing in.

Absolutely. Don’t factor the spikes, and look at the average over a five-year period.

What about the question of whether we’re saving too much for retirement, and if we are, should we just… stop? That feels scary. I’ve got nine times my monthly income saved for retirement [which is more than the book recommends at this stage in my life], so do I not save anything else for retirement over the next five years?

It depends. If you have a company match, then under no circumstances do I want you to stop. I do not want you to miss out on the benefit of a match. It’s free money. Plus, if you put in 3 percent and your employer puts in 3 percent it’s a 100 percent return, and nothing else’s going to give you that. If you factor in the tax benefits, it’s truly remarkable.

If you don’t have a match—

And sadly, I do not—

Then that goes back to your question about freelancing, and I want to drill into that a little more.

When you’re a freelancer, money towards growing your business is an investment in the business. So, just like you put money into a stock or a mutual fund, money you put towards your business is an investment, which is a form of saving.

People tend to overestimate the future return and underestimate the risk with that, so you want to be careful. You also need to carefully and strategically evaluate your business spending, but that’s a part of savings.

Whatever you’re doing is working. If your income’s growing by $20K a year, and let’s say you put $2,000 towards a computer and, I don’t know, whatever you did to source those opportunities, it worked. Do it again.

I turned in all my paperwork to my CPA last month, and I spent a little more than $2,000! But yes, I’ve been very lucky and I’ve worked very hard.

So those are investments, and when that money comes back to you you need to repay that investment, like you’d do with any other investment. Early in our lives, some of the best investments you can make are those kinds of investments, like you’re doing.

That’s Part 1. Part 2 is that the more you’re a freelancer or a small business owner, the more you have to value liquidity. Your paycheck can and will change, especially in a recession. It’ll probably change more than others’, so you need to have more money in reserve, more liquidity, and you need to value flexibility much, much more.

Depending on levels of income, small business owners and freelancers do have some additional tax strategies they can use to sock more money into retirement plans than the rest of us. So this is really a question of income relative to the overall savings rate.

Generally, if your income is over $100,000 and you’re saving more than 15 percent of your income, then even though you’re ahead on your retirement account, it’s still going to be very beneficial to put more income into that retirement account from a tax perspective. You’re going to get approximately 30 cents on the dollar back from the federal government, as a thank you for saving into a retirement plan. This is a huge return that you can’t capture otherwise.

If your income is below—it depends on if you’re married or have kids, but if you’re married and you have kids and your income is below $50,000, or if you’re single and your income is below $35,000, you’re not getting that much tax benefit on your retirement account savings anyway, so then you might stop saving for retirement [if you’re already ahead].

The math on that is: are you getting a meaningful amount of tax benefit on that contribution? If you are, I think you should still continue to put money at your retirement plan, though maybe at a lesser level. Don’t slam on the brakes, but reframe your goals.

Too many people live check-to-check, and too many small business owners and freelancers slam money into their retirement accounts and they can’t weather the next storm. That’s what I’m trying to avoid more than anything.

I am so excited to learn that investing in my business can count as a form of savings—with a few caveats, because if you’re not getting a return on your investment then you’re not bringing in any money to save—because one of my biggest struggles as a freelancer has always been how to balance the money I need to grow my business with the money I feel like I should be putting into a savings account, and still have enough money left over to buy a new pair of shoes when I need them. (Last night I walked home from my volunteer tutoring gig and considered throwing the shoes I was wearing directly into the garbage.)

More on that tomorrow. Today, I want to thank Tom Anderson for talking with me, and for providing me with a useful and practical financial guide.

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