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Understanding Why Billionaires Have So Much Debt

Justice is a business owner. He has been running multiple online businesses for the past 5 years.

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For us regular folks, paying off debt is typically one of our top financial objectives. We want to pay off our debts as quickly as we can to reduce the interest we pay, whether they be college loans, car payments, or mortgages. Most of us would completely avoid debt if we had the money to do so, yet ironically, some of the richest people in the world also have the highest levels of debt.


I'm certain that everyone reading this has heard of Elon Musk's plans to buy Twitter for $44 billion. Elon could certainly pay in cash given that his net worth is currently over a quarter of a trillion dollars. However, he intends to incur a significant debt. The current strategy is for borrowing $13 billion against Twitter and $12.5 billion against his share in Tesla. This indicates that he will borrow a total of $25.5 billion. Now that the possibility of a margin call has been reduced, Elon might decide to pay more cash when the sale closes, but the core question still exists.When you don't have to, why even bother dealing with debt, banks, and interest payments?


This is true for all purchases, not just big ones made on Twitter. Even though the costs of houses, yachts, and private planes represent a tiny part of billionaires' net worth, many of them will take on debt to finance these acquisitions. Before he made the decision to sell all of his properties and go to Texas, Elon had 5 mortgages totaling $61 million. So why do billionaires willingly accumulate such high levels of debt?

Maximizing Returns

understanding-why-billionaires-have-so-much-debt

To optimize their earnings, wealthy people often choose debt over paying cash as their primary payment method. They are already wealthy, thus they are well aware of how to generate substantial returns on their investment. These people are specialists at continually outperforming the market, whether it be by investing in stocks, real estate, or starting a new business with the money.


Consider the case of Tesla. The stock has increased in value from $4.15 to $870 since they went public in 2010. This works out to an astounding 200x in 12 years, or a 54.585 percent annual rate of return. And those are simply the profits Tesla has generated since going public. The majority of profits are often realized prior to a company's IPO. So, for Elon to sell his Tesla stock and, say, purchase Twitter, Twitter would need to consistently generate more than 54.585 percent annually. Tesla won't continue to grow at this rate indefinitely, but I think you get the idea. For Twitter to be a profitable investment, it would need to continuously outperform Tesla's yearly return. And the reality is that this is unlikely.


First off, it doesn't appear that Elon is even purchasing Twitter in order to profit. He appears to be purchasing it with the intention of bringing about change and for social causes. Therefore, it's unlikely that Twitter will develop like Facebook and achieve a trillion dollar market cap or whatever, even though it may organically expand to $100 billion or something under Elon's leadership. Given that Twitter is only a side project, it makes sense from Elon's perspective to limit the funds he does tie up with it. This same approach applies to much smaller purchases as well.

Let's revisit Elon's $61 million mortgage from the beginning of 2019. Tesla had recently emerged from a manufacturing rut and was on the verge of bankruptcy at the time. In June 2019, Tesla shares really fell to just $36 per share, not long after Elon took out these mortgages. Imagine Elon chose to give up obtaining a mortgage in order to pay for his properties by selling $61 million worth of Tesla stock. Tesla stock has increased roughly 23 times since this low point in 2019, thus the $61 million he sold to buy his properties is now worth $1.403 billion. Elon would have missed out on $1.3 billion even if we assume that the properties increased in value to $100 million, and it doesn't even account for potential future growth.


When discussing depreciating assets like a private plane or a yacht, this argument becomes even more important. It makes no sense to pay for these assets up front because they are practically guaranteed to lose 70 to 80 percent of their worth if you own them for a long time. The only reason you would pay for them in full up front is for your own piece of mind, but taking on debt is unquestionably the best course of action in terms of returns.

Illiquid

One of the main reasons billionaires take on debt, besides attempting to optimize profits, is that they have no other option. While they may have tens or even hundreds of billions of dollars on paper, the large majority of this money is illiquid. For instance, Elon raised the money he promised to contribute to Twitter by selling $8.4 billion of Tesla stock. The Tesla stock dropped 12 percent in a single day as a result of this sale alone. Imagine if Elon had to sell five times as much to raise the entire amount needed to purchase Twitter. Tesla would very likely be down 60 to 70 percent, if not more, by the time he finished selling.


Along with his own company's stock falling, he would also face a lot of criticism from Tesla shareholders. The fact that Elon sold Tesla stock in order to purchase Twitter has already upset many Tesla stockholders. Many of them perceive Twitter as a pointless distraction in addition to being an undesirable trade. Additionally, they haven't been afraid to keep their opinions to themselves. "I hate that you sold shares, Elon," one Twitter user wrote. If Elon led the stock to drop by 60 or 70 percent, he would be almost roasted alive. And other founders also share the same situation.


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For instance, it took Bill Gates 25 years to sell his Microsoft stock. These guys at least have the choice to sell if they truly want to. Due to stock vesting, many smaller billionaires have no other option. If a business is going through a difficult time, the owners typically don't want top level executives or employees to sell off a lot of stock. These folks selling would just lead to a further decline in the shares and worsen the company's financial situation. Therefore, the majority of businesses implement a stock vesting policy that prohibits employees from selling their stock for a predetermined amount of time. For example, the vesting period is 4 years for Google and Apple. Thus, even while it's technically true that Sundar Pichai or Tim Cook made $281 million or $265 million respectively last year, they won't actually have access to that money for many more years. Merely their cash reward, which for Sundar Pichai is only $650,000, is available to them immediately. As a result, even though someone like Sundar or Tim can comfortably afford a $20 million or $30 million property on paper, they are forced to pay over time since they lack the funds up front.

Minimizing Taxes

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While improving returns and maintaining liquidity are important factors, we haven't even touched on taxes. Many people believe that billionaires should pay far higher taxes, but in reality, this wouldn't even make a difference because these people employ various smart tax evasion techniques, one of which is borrowing money. Even though they'll have to pay 3 or 5 percent interest on their loans, they'll be able to save a lot more money in taxes.


Long-term capital gains are currently taxed at a rate of 20 percent. Additionally, you'll have to deal with state income taxes if you reside in California like many of these billionaires do. You'll have to pay California the entire 13.3 percent tax rate because it doesn't distinguish between capital gains and ordinary income. This indicates that your overall tax burden is 33.3 percent. I'm not here to debate whether this is a fair price or not, but this makes it very difficult for billionaires to sell their stock.


Given Elon's $61 million mortgage, we previously estimated that, if he had paid for these homes in cash, Elon would have forfeited $1.3 billion, but this figure excludes taxes. Elon would have had to sell $91.5 million worth of stock to pay for these properties altogether if we add a 33.3 percent tax. Again, assuming that the value of the Tesla stock has increased 23 times since Elon purchased these properties, $91.5 million now is equivalent to $2.1 billion, suggesting that Elon would have outright lost $2 billion. And looking ahead, the $91.5 million acquisition, which was a tiny percentage of Elon's wealth even in 2019, would be worth $10 billion if Tesla grows by 5x within the next 10 to 20 years.


Therefore, you want to be as involved as you can be and you definitely don't want to lose any money to the IRS when exponential growth is working in your favor.

Inflate Away Debt

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Even though all of the reasons we've discussed so far are excellent ones, the wealthy would still borrow money for one reason even if none of the others applied: inflation. Given the rapidly growing cost of living over the past year, inflation has been terrible for average Americans. But it is rather advantageous for those who are in debt. The fact is that inflation won't cause the amount of money you owe to increase. But you will make more money overall.


Unfortunately, especially during periods of severe inflation, earnings don't always keep up with rising prices. However, even if your salary doesn't quite keep up with inflation over the long term, this method is still useful. It performs best when your income scales perfectly with inflation. For instance, a dollar today is barely worth 50 percent of what it was in 1992. Let's now imagine that you obtained a $200,000, 30-year fixed-rate mortgage in 1992. Your mortgage payment may initially take up half of your net income. But let's imagine that after 30 years, thanks to inflation and promotions, your salary doubles. The same mortgage payment only covers a quarter of your net income at this point.

Those are rather modest growth estimates. What if your income increases by 5 or 10 times over the course of 30 years? By the time you pay off the mortgage, it will be a minor expense. And if you own a company in a region with rapid economic growth, like many billionaires do, this is very relevant to you. Also, this tactic isn't just employed by billionaires.


This is one of the main methods used by governments to lower their long-term debt loads. Simply inflated, they remove it. I would suggest that governments have now carried this to an undesirable point, but that is a topic for a completely different discussion. Simply put, wealthy people prefer to take advantage of the fact that paying off debt in the future should be simpler than it is at the moment.

Time to Go in Debt?

understanding-why-billionaires-have-so-much-debt

After hearing about all of these benefits, many of you may be considering if this tactic would be effective for you. Sadly, the answer to that question is probably no if you have to ask it. The safest course of action for the average person is to either avoid taking out school loans, car loans, and credit card loans altogether or to pay them off as quickly as possible.


The average individual could use this method in one specific area, but they would need to be committed and disciplined in order to do so. It would be wiser to take out a 30-year mortgage rather than a 10 or 15 year mortgage and invest the monthly savings in the S&P 500. But it's preferable to just take the shorter mortgage and pay off the debt if you know that you won't be that consistent and will wind up wasting this money rather than investing it.


It makes sense for many billionaires to use debt as opposed to cash. Would you continue to incur debt if you were a billionaire?

© 2022 Justice Ndlovu

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