Now assuredly one might cycle through all three stages (and back) throughout their lifetime. Moreover, it’s a bit a simplification in that you can do these things simultaneously. However, it remains that at any given time you are a net payer, a net earner or a net owner.
Paying interest is simple enough. If you owe on a credit card balance, student loans or a mortgage you’re paying for the privilege of upfront cash. Someone agreed to front you the funds today in expectation of receiving more money from you in the future. They didn’t do it because they’re nice. Well they might be nice, but the real reason is in anticipation of adequate future returns.
Whatever your situation, you likely want to get out of the “paying interest” stage as quickly as possible. If you don’t do it in a predetermined and timely manner, the loaner can legally take your stuff (including wages) and more importantly take away your freedom. You don’t have time for that.
The second category of financial person is remarkably better off than the first. Instead of consistently owing, the saver earns interest on their hoarded surplus. This provides you with freedom, not too mention lower expenses and less financial stress. As an added benefit, you get richer by the day.
Saving is good, but owning is better. Which brings us to the final category of financial person: those who own the bank. Note that this frame of thought could be literal – owning shares of Wells Fargo (WFC), as an example – or as a proxy for any number of different equity ownership stakes. Say owning a rental property, part of Coca-Cola (KO) or a private mortgage business.
So, why is being an owner better than a saver? Conceptually, that’s easy: savers earn interest from a bank. A bank is able to pay interest by earning even more on those borrowed funds and then giving you a small cut as a cost of doing business. Today that cost is very low.
All equity ownership stakes work in a similar manner. The bondholders or interest recipients receive fixed and periodic payments, while the owners roll around in the spoils – private jets and all. In a profitable business the rewards are routinely greater than the costs.
Banks are a prime example, but the idea works with any moneymaking business. Take McDonald’s (MCD) as an illustration. Presently the company has a variety of bonds outstanding. One particular issue has a 2022 maturity and a current yield of 2.66%. Now earning 2.66% each year is a whole lot better than having to pay 2.66%. Yet having an equity stake in the company is overwhelmingly more profitable.
The company doesn’t just take on debt and later repay it. Instead, it uses those low cost funds to invest in more lucrative opportunities – resulting in a large positive spread between what it makes and what the company has to pay back. That excess – profits – is divided between the owners via reinvestment, dividends or share repurchases.
Note that this excess is after interest payments, salaries, costs and everything. Last year, McDonald’s excess came in to the tune of roughly $5.5 billion. The company chose to return $3.1 billion to shareholders via dividends – or $3.28 per share owned. Based on today’s share price, the current dividend yield sits at 3.7%. Think about that. The dividend payment alone is 1.4 times higher than what is being paid by the aforementioned bond.
More impressive is the idea of growth. While the interest rate stays the same for the life of the bond, the dividend often grows over time. In the case of McDonald’s, the company has not only paid but also increased its dividend for 38 consecutive years. So you start out with a higher yield and you also get a raise each and every year.
But it gets even better. Remember, McDonald’s excess last year was $5.5 billion. It only allocated $3.1 billion to give back to shareholders in the form of cash dividends. The company took an additional $1.8 billion and used it repurchase shares. Conceptually this means that for every 100 shareholders that existed last year, there are only 99 remaining stakeholders today. The company bought out roughly 1% of the equity partners on your behalf. Moving forward you don’t have to share the profits with as many people – making your stake more lucrative.
The remaining profits were reinvested into the business. As time goes on, these retained earnings will lead to larger profits, in turn making your stake more valuable. I could go on, but I think you get it: an equity stake can be tremendously more rewarding than simply collecting interest or bond payments.
This was just one example, but it holds across the field. It’s why “ownership” has turned in annual returns of 8%+ over the last 35 years, while “loanership” returned roughly 5% yearly during the same time period. Five percent is infinitely better than negative returns (paying interest), but the extra benefit from “owning the bank” can compound widely over time.
The idea is to move from paying to earning to owning. So, which type of financial person are you?