Debt: It's Not a Four-Letter Word
With so much recent focus on this country’s all-too-regular debt ceiling drama, I want to spend a moment to make a proclamation: debt is not a bad thing. The caveat (as I will tell my son with his Halloween candy) is some is good, but too much can be very bad. I will even take it a step further and say, when used correctly, debt can be a very powerful tool to maximize one’s wealth. It gets a bad rap from the media and famous financial authors because it is very easy to misuse, but let’s examine with a practical lens what exactly debt represents and how it can help or hurt.
In the financial world, the word “leverage” is sometimes used to describe the amount of debt that a person or company has. Looking at the base of that word, we can see the primary use for debt: using a little to move a lot. The easiest example is taking out a mortgage to buy a house. With $40,000 of cash, assuming the standard 20% down-payment, you can purchase a $200,000 asset by signing a few pieces of paper promising to pay it back. Of course, you must pay interest on the amount borrowed, but the instantaneous increase on the asset side of your balance sheet is the effect of leverage. This can be seen in all areas of our economy. From residential housing to small business loans to government bonds - borrowed money is the lifeblood of our economic system. It allows us to take risks and companies to innovate.
Continuing with the example of the mortgage, a very common question arises in our line of work: “should I pay down my mortgage faster?” As we like to say around here, “it depends.” By paying a mortgage down faster or selecting a 15-year instead of a 30-year, you are limiting your options and potentially incurring an opportunity cost with that money. Some people sleep better at night knowing they won’t have a monthly auto-draft from their checking account, but that mentality does have its costs. For one, as you put extra money towards your house, the equity you build is not exactly liquid, meaning if an immediate need arose, good luck getting the bank to rush that home equity loan to pull some money out. Secondly, money that gets used to repay the bank could be deployed elsewhere into a even a modest investment strategy. With interest rates being so low, the rate of return “hurdle” to clear is barely off the ground.
Lest we go too far with what may seem like a love of borrowing money, let’s snap back to reality and realize the sobering fact that it is far too easy to get carried away and borrow more than is affordable. The wounds of the housing bubble are still fresh almost fifteen years later. Credit card revenues are built on people spending money they don’t have and those balances can balloon in the blink of an eye. How can this be avoided? Approach your finances with the eye of a credit bureau. Look at not only the total amount of debt you carry, but also the monthly payments it takes to service that debt. Cash flow and household balance sheets go hand in hand. Another way to efficiently manage debt is to focus on productive assets with your debt. A house that should appreciate in price over the life of the mortgage = good. The all-inclusive vacation with the unlimited drink package that gets put on the plastic = not great. Car loans would be a gray area because a car is a rapidly depreciating asset, but interest rates are at a level where a loan would be palatable.
Many of these money decisions don’t have a right or wrong answer. Everything exists on a continuum (see what I did there?). Personal finance can be an emotional topic and debt can magnify those emotions. During our process, we examine the entirety of your financial situation and make suggestions from an objective viewpoint. So what do you think? Is your debt working for you or against? If you’d like to talk to us about it, reach out and let’s dive into the nuances together.
Author: David Rath, CFA