Labeling Debt To Make It More Palatable
| February 24, 2011 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
Consumer Debt Is Consumer Debt
I think many people are fine labeling credit card debt as bad, but we sometimes have an artificial hierarchy with respect to other debt. We elevate student loans and mortgage debt as sacred. After all, we need an education and to live somewhere. We justify car notes because we need to get to work. First, there are ways to get an education, purchase a car, etc. without debt, albeit they are less pleasant. Also, your income statement doesn’t really care about these distinctions; all it knows is that money spent on these things is money that isn’t going towards your financial solvency, independence, comfort, and wealth. I wholeheartedly believe in the vast majority of situations, the labeling is immaterial and should be treated as such. It’s debt and should be avoided and/or paid off. The main exception is that it is reasonable to continue retirement investing while paying off a mortgage. It’s really that simple.
Home Mortgages Are Different
Some feel that mortgages are a different beast. They argue that while the mortgage balance is a liability, the value of the home is an asset. That’s true, but value is subjective and becomes most relevant upon selling an asset. This is why home equity is increasingly not being included in surveys, such as the annual World Wealth Report, which defines high net worth individuals as “those having investable assets of U.S. $1 million or more, excluding primary residence, collectibles, consumables and consumer durables.” Until it is time to sell, the concern should be how the asset is impacting your cash flow and for how long. After all, your income is your most powerful wealth-building tool. If it is obligated via a mortgage (or consumer debt, property taxes, maintenance costs), then you are losing valuable opportunities to invest and for your investments to grow.
Convince people that debt is good
Even if we consider the merits of “good debt,” most debt doesn’t qualify. If the term “good debt” is legitimate, I believe it would best refer to debt that is producing income now. For example, perhaps if you are earning a significant income from your debt and your leverage ratio is very, very, very small: meaning you can write a check tomorrow and be out of debt, then perhaps you are in debt that some would refer to as “good debt.” This is a very conservative view of debt and obviously less preferable than avoiding debt altogether, but I would argue labeling debt that benefits your income statement as good is at least understandable and possibly defensible. However, I fail to see the validity of classifying debt resulting in negative cash flow (before or after accounting for depreciation) as good. I seriously doubt those who have achieved significant wealth would view such behavior positively. After all, 75% of the 400 richest Americans (Forbes 400) believe “the best way to build wealth is to become and stay debt-free.” In other words, it is hard to get ahead financially espousing liabilities as assets, good conscience or not. Whatever benefit that is achieved by debt is more than offset by the risk assumed by the borrower. Using debt for investments or businesses puts the borrower at risk of making more mistakes and for the implications of mistakes to be magnified. Indeed, if you looked at your risk-adjusted rate of returns, borrowing money, even for these purposes, would not appear so casual.
If you don’t eliminate risk, at the very least minimize it. I was delving into the finances of a big proponent for people building wealth by keeping “good debt.” First, he recommends having at least a full year’s salary (not expenses) in cash (not equity). He also keeps at least a 75% equity position in his primary home and could pay off the remaining 25% at any moment. Additionally, his income exceeds his expenses (including his debt obligations) by over a 12:1 ratio. Next, he recommends that every real estate deal must yield positive cash flow, from day one. If I didn’t know any better, I would say he sounds downright conservative financially, despite shocking statements like “I’m rich because I’m deep in good debt.”At the end of the day, proclamations about how you love debt and are rich because of it may be useful to sell books and garner media attention, but clearly being financially-conservative, solvent, and liquid has kept the foreclosure wolves at bay. Generally, anyone who has any sort of longevity in real estate or business cannot remain chronically over-leveraged.
Concluding Thoughts
Spare me the moral posturing or the detailed theoretical calculations telling me why debt is good please! Even the “good debt is alright” gurus don’t really drink that kool aid (or they don’t last). It’s not that I’m mad at you for calling your debt good. I just don’t believe you. We’re still friends though, and because we are let me share something personal with you. By recognizing the debt for what it really was, a restraint on my cash flow, I was able to focus my efforts on eliminating it. It wasn’t easy nor pleasant, but it certainly was simple… and relatively quick! Often the best advice in personal finance works out that way.
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.
I really like the recognition that debt for education shouldn't be put up on a pedestal. IMHO too many people are willing to go as far into debt as it takes to get an education and end up graduating into low paying jobs with a humongous student debt overload.
Also, recognizing that the income statement doesn't recognize the distinction is important. The debt servicing burden is the same no matter where it comes from.
Good outside the box post to get people to think.
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After all, 75% of the 400 richest Americans (Forbes 400) believe "the best way to build wealth is to become and stay debt-free."
I almost don't believe that. You would be very hard-pressed to find anyone on that list who hadn't turned to debt to finance their growing businesses/investment portfolios.
The problem is everybody goes into education debt assuming everything works out. For many, it doesn't and then they end up with the debt or no degree, or with the debt and no desire to work (someone who wants to be a SAHM), etc. Life is dynamic, and things often don't work out as expected.
My recent post Labeling Debt To Make It More Palatable
I agree debt is debt! I differentiate debt based on interest rates! With prime so low, any debt above 5% needs to be replaced, refinanced, or changed! Of course, you could pay it off. It is harder with a high interest rate. I have never had credit card debt, but I have used my line of credit. My line is at a much lower interest rate.
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Let's start with the assumption that all debt sucks. Some just sucks a little less than others.
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Debt is debt. I think once people agree on that point, the other distinctions are not nearly as important or controversial..
My recent post Labeling Debt To Make It More Palatable
All debt sucks!!! That's a very fair statement, and of course I'm right with you. Thanks for dropping by!
My recent post Labeling Debt To Make It More Palatable
The financial service companies have done a great job trying to convince consumers that debt is not a bad thing and have provided lots of easy money for those willing to fall for the sales pitch. The biggest suckers always go bankrupt regardless of income levels.
I've always believe families should manage their finances like corporations….. by that I mean they should produce quarterly and yearly income statements, balance sheets and cash flow statements. Just understanding how to produce these documents is a financial education in itself, and is an eyeopener when is comes to assessing overall financial condition.
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I couldn't agree more… on all accounts! I definitely believe families should learn how to do financial statements and have been an advocate for years.
My recent post Labeling Debt To Make It More Palatable
One distinction is whether or not the debt is personally guaranteed. I think that's a distinction worth looking at.
Also, always remember that venture capitalists are greedier than banks. Yes, debt may rob your cash flow. However, VCs can take tens of millions of dollars that should have been yours.
I understand your point; however, most people stand to make their first few million WITH VC than without. To earn such resources without incurring debt by growing more slowly or having investors is certainly more reasonable to me. If you don't like VCs, consider friends/family the primary source of business funding anyway.
My recent post Labeling Debt To Make It More Palatable
I do not classify any debt as all good; I do classify some debt as not ALL bad. Student loans and even some car payments, for example, are not ALL bad. But all debt does reduce your net income and so has that negative aspect about it; so no debt will ever be all good in my book.
Mortgage is different, as you write but you did not mention why it is unique among all other forms of debt.
Assuming you have an option between renting or buying your housing (via a mortgage), you need to remember that rent is not the financial equivalent of buying. Rent is the cost of housing while buying is the cost of acquiring the asset underlying the mortgage — the house and land it sits on.
And, when you are buying you effectively get free rent! The bank is not charging you to live in the house, that is not what a mortgage payment is. And, that being the case, you receive the market value of what your house would rent for as imputed income.
When you get a mortgage, you have turned an expense (rent) into a debt; and the difference between a debt and an expenses is significant: A debt can be paid off.
Once you do pay off your mortgage, you are done with it but if you rent, you never retire that expense.
And debt can be used to finance liquidity. For example, the mortgage balance on my primary residence is appx $70,000. I could pay that in cash today if I wanted to but I prefer to keep the funds more liquid as cash rather than less liquid as equity.
And there is a perspective by which to consider debt that you didn't mention: Debt payments represent committed spending. It is that part of your income over which you have no control. It is you working for someone else. Ideally, you would have control over 100% of your income. In other words, the ideal debt load is ZERO percent of your income.
Mine is presently less than 5% of my income; all of it PITI on my primary residence and the PI part of that I can eliminate at will.
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Yes, I didn't fully explain mortgage debt. I just wanted to highlight my problems with how it is perceived. I do agree that debts can and should be paid off, which is really my point anyway.
You are certainly right about the committed spending. I definitely agree and have addressed that elsewhere: http://frugaldad.com/2010/09/29/radical-thoughts-…
I think you are the perfect example of someone who does have some debt but is being extremely conservative. I think if people truly understood how small a portion debt is in your total financial picture, I think no one would espouse your case as the prototypical American family. You have clearly done well for yourself. My hope is that other people will gain control over their finances as well. From my experience and observations, it's easier and quicker to do that eliminating debt than maintaining the status quo.
My recent post Labeling Debt To Make It More Palatable
I see where you are coming from but I don't look at debt as good vs bad (or just all bad as you do), but rather Smart Debt and Stupid Debt. The house you purchased (with mortgage) isn't necessarily good or bad but rather smart or stupid determined by various factors such as size, location, terms, etc.
Same with education – it isn't all good or all bad. If you use debt to get your MBA and turn yourself into a money making machine then it was smart on the other hand if you used 120K of debt to pick up a degree that only lets you make 32K as a social worker…probably not a smart decision
The term "good debt" is certainly not accurate, but there are better types of debt to have over others, and I think thats what we tend to hear about more often. Ok so all debt is "bad debt", I agree, but if I somehow hae 5k on an interest free credit card with 24 months to pay it off, id rather take the 5k and invest in my online brokerage account and earn anything higher than that, pay off the credit card debt when it comes due, and keep the earned interest. It all depends on how u look at it. I go in to this a bit on my personal finance blog as well..
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Evan, I understand where you are coming from, but I do think the implications of what you are saying are scary: you are saying the actual outcome is the primary criteria judging whether debt is smart or stupid. I disagree, and I don't think many people judge smart or stupid this way because using that same logic, the only time it is stupid to have unprotected sex or drive drunk is if you have a bad outcome. I think sometimes you get lucky, but that doesn't mean that you didn't assume dangerous risk in doing so, which many people would not characterize as smart despite your good fortune.
My recent post Labeling Debt To Make It More Palatable
I certainly would never assume such risk, but that's because when I calculate a risk-adjusted rate of return and taxes, I typically am better off paying the bill. In the case where you are paying no interest, it's more difficult to make that case, but human nature does say that people on average spend 12-60% more when spending on credit rather than paying with cash. I won't go into the reasons why, but I still think the person who keeps their finances simple and frugal ends up ahead in most cases.
My recent post Labeling Debt To Make It More Palatable
Mortgage debt has actually helped motivate me to be the best employee at possible at work, which has resulted in survival, raises, and a couple promotions. It was the kick in the pants I needed to help me keep going b/c sometimes, I start to fade!
It doesn't hurt that the place now provides rental income too, but that's besides the point.
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Thought-provoking post. I think we all need to examine debt in a new light. Mortgage debt can be good debt, but isn't necessarily good debt (as the housing crisis has taught us). Same goes for education debt: it can be good, but isn't necessarily good just because you are using it to get a college degree. There are lots of other factors at play.
I am of the belief that there's really no "bad" debt or "good" debt – debt is just a tool, and like all tools it can be used wisely or badly.
I think if the economy ran on a currency with a stable supply, debt would be used FAR less than it is used today. Debt really should only make sense if it can be used to make a productive investment that will return more than the natural growth of the economy, but the way the monetary system is structured today it becomes almost obligatory to use debt if you want to buy a home, and this magnification can lead to issues when rates rise or credit contracts, not to mention the misallocation of capital that can come when rates are far from where they "should" be, thus placing a lot more risk into the system overall.
Sam, I believe I can understand where you are coming from, and that's really my point. You can play with debt or you can eliminate it and use your cash flow to build wealth. I find it challenging to believe that most people use debt in a manner that posses little to no financial risks.
My recent post Labeling Debt To Make It More Palatable
Thanks so much for your comment. To be honest, I wish we would stop labeling debt altogether. It is debt. Why do we have to make it a morality issue if there is no problem with it?
My recent post Labeling Debt To Make It More Palatable
I agree that this debt-hierarchy is completely arbitrary. My problem with using debt as a tool is that it adds risks and magnifies mistakes. My underlying hypothesis is that most people use debt badly despite proclamations to the contrary.
My recent post Labeling Debt To Make It More Palatable
Home debt is the only debt that I truly don't freak out about with respect to other priorities, meaning funding retirement, emergency funds, investing for education etc. However, personally, even it makes me uncomfortable. Where you live does make a difference too. I have been exposed, via TV, to some of the real estate prices in Toronto for example.It wasn't pretty!
My recent post Labeling Debt To Make It More Palatable
Starting with an attitude that all debt is bad is a good way to avoid debt.
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Nice blog..I am looking forward to read your next great article.
I think you and Moneycone have it right. Start with the assumption that all debt is bad and should be avoided at all costs. It is possible to do but requires a lot of planning, foresight, and some sacrifice. I would probably remake some of my decisions had I taken the above attitude. As it is, I am where I am and will be working to decrease debt and increase cash flow.
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Many of the student have to undergo education debt and For many, it doesn't and then they end up with the debt or no degree, or with the debt and no desire to work.
the thing is you must have the capital to start a business and if you have no backups you need debts
The amount that people have to spend and get themselves into debt for, when it is just an education is a joke. Especially as nowadays, the education does not guarantee an instant career.
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I think it is pretty hard to go through life without debt at all. Sure you don't go looking for it but you are bound to go into it at some point. If it isn't a mortgage it's school debt etc. The key is to get out of it as soon as possble.
Plus I don't think it is good to borrow from friends and family. There is too much risk involved.
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