Throughout the lexicon of financial advice in the marketplace, there are many different views regarding the role of debt in our lives. The traditional view is that debt causes us to make interest payments that deplete our wealth and erode our ability to build wealth. In the case of the mortgage crisis, many lending institutions and government agencies encouraged excessive lending to borrowers that were at very high risk of default. This even prompted some financial authors to proclaim that all debt is bad, regardless of what it is used to finance, and regardless of how it is structured.
It is certainly true that using debt to finance consumption purchases is fraught with danger. (This is typically called “consumer” debt) The problem you run into is that when consumption is financed with debt, you end up paying for something that either doesn’t exist anymore such as food & drinks or something that is currently worth less than what you paid for it. (The overwhelming majority of consumer purchases decline in value after they are purchased)
Automobiles also fall into this category but are frequently financed because most people do not possess enough cash to purchase them outright. Many of these items are necessities or highly sought after luxuries. The thing that we need to keep in mind is that these expenditures should be made with our current income … if we allow ourselves to pay interest on the purchase of something that is consumed or that depreciates in value, we will quickly be consumed.
Conversely, you can also use debt to purchase something that increases in value such as your home. This type of transaction provides a double-benefit. The value of the dollars you use to repay your loan is eroded by inflation while the value of your home increases. The difficulty in this strategy is that you can’t spend the increase in your home equity until you sell the house and realize the gains. One way to get around this crunch is to use debt for purchasing rental/income investments. The income collected is used to pay the interest on the loan and you benefit from the increase in the asset value.
Generally speaking, the fundamental basis of all wealth creation is to invest capital at a higher rate of return than its current use. This process systematically directs capital toward its highest and best use … it also benefits the investor/entrepreneur by generating a rate of return on money that has been borrowed. The important factor to consider is that debt used to finance investments is like a magnifying glass … it will amplify both good and bad results. When debt is used prudently, it can create tremendous value. When debt is used foolishly, it can destroy tremendous value.
A third option has generated considerable attention in recent years, and this is the notion of living with no debt at all. The advantages are quite clear, since you will have total ownership of your assets, and will not owe interest to anybody. This desire stems from a view on the part of many people that debt is inherently bad. The truth is that debt is neither good nor bad, it is simply a tool. It is a tool that can create great benefits or create great problems … the difference is all in how the debt is used. Debt that is used to finance a prudent investment or business can generate returns that exceed the cost of carrying that debt by a considerable margin.
Consider the common advice to pay extra principal each month on a mortgage. The rate of return that you will earn by following this advice is equal to the interest rate that you pay on your mortgage. For example, if you pay 5% interest on your mortgage loan, paying extra principal each month will generate a 5% internal rate of return for your additional principal payments. If you consider 5% to be an exceptional rate of return, then this may represent a highly prudent decision. If you are able to earn considerably more than 5%, paying down your mortgage may be trapping equity when you could be creating wealth.
In the end, the way that we use, view, and live with debt doesn’t have anything to do with the debt itself. Like all tools, debt can be used for both constructive and destructive purposes. It is our responsibility to ensure that we use debt prudently so that it generates value. If we are going to use debt as a tool in our lives, it is critical to ensure that the things this tool is being used to purchase are of high value. This is the best way to avoid the “bad debt” trap that ensnares millions of people each year.