How to Use Debt Wisely
Last week we talked about financial transparency. This week I want to cover a more controversial topic how to use debt. We are going to cover three main area. What is Debt, Is Debt Evil, and How to use Debt Wisely.
So what is Debt
Debt, in general, is an obligation to pay an individual or company back a set amount of money at a future date. Dictionary.com defines debt as something that is owed or that one is bound to pay to or perform for another. Another way of putting it is you're giving away your future productivity to someone or a company for a present benefit.
To me as a CPA debt is a tool. There are different types of debt, and each has its advantages and disadvantages. Each comes with risks. The two broadest forms of debt are unsecured debt and secured debt. Unsecured debt is debt which you are not required to provide anything of value to get. Examples of unsecured debt are credit cards and student loans. Secured debt is debt which you must contractually guarantee with something of value. Examples of secured debt are mortgages and auto loans. The biggest difference between the two is if you don't pay your unsecured debt the holder of the debt has to take you to court for them to get money from you but if you don't pay your secured debt the debt holder will take the item you secured it with. Like for a car loan, they will come and repossess the car.
Is Debt Evil
We live in a society of easy lending. Our culture says that borrowing money isn't bad, but if you overextend and have to go through bankruptcy you are a fool.
But what is debt for. I believe if we can answer this question then it becomes obvious that debt is just a tool which some use as intended and other use foolishly.
Before I address that I need to address Proverbs 22:7. For those of you who don't live in the bible belt or are unfamiliar with the passage. Proverbs is a book in the Bible and Proverbs 22:7 says in the NIV (New International Version) of the bible "The rich rule over the poor, and the borrower is slave to the lender." From this verse and this verse alone many Christian say "see if you have debt you are a slave to someone, and therefore debt is evil." I don't have space in this post to do a proper critic of this method of thinking but in short in the USA debt does not in any manner of speaking equal slavery. Secondly, this verse in the bible is more of an indictment of the rich of that time than the poor. Craig Ford at Money Help for Christians has a pretty good blog post about this which you can find here.
Back to the issue at hand. What is the purpose of debt? Debt has a several of good purposes.
- It can temporarily bridge a cash-flow gap between periods of unemployment
- It can increase your buying power without having to sell longterm assets.
- It can smooth out cash flow
If you keep the above in mind debt becomes a tool to help provide financial stability and growth.
How to use debt wisely
Let talk about each of the above purposes of debt a bit more in-depth which should give you an idea of how to use it wisely.
Example one, using debt to temporarily bridge a cash-flow gap between periods of unemployment.
- Say you were just laid off from a job at the beginning of your career. You probably don't have a lot of saving built up and what you do have would be depleted in days. Your first step would be to cut back as many expenses as you can, but more than likely your negative cash flow would put you on the street in no time. That is where debt comes in. You use unsecured consumer debt to help bridge the gap between what you have in savings and what you are spending to give yourself enough time to find a new job.
A lot of people are going to disagree with this, and that is okay. If you don't have enough cash saved you don't have any options, and this one is probably your best chose since the likelihood of getting reemployed somewhere is relatively high. Now you would need to reassess your situation monthly and allow yourself to be accountable to other trust individuals in your life.
Example two, using debt to increase your buying power without selling long-term investments.
- If you have a large 401k or IRA and you want to buy a house, and the money in the 401k or IRA is enough to pay cash what should you do? Get a loan. This is also probably an unpopular opinion. But think about it with me. The money in your 401k or IRA should be making anywhere between 8% to 12% return on investment (If it isn't you should get an investment advisor). If the home you want to buy is $300,000 and you could get a loan with 20% down at 4%, you would pay $194,048 in interest. If your $300,000 investment made a return of 8% or 12%, it would be worth $3 million at 8% or $9 million at 12% over the 30-year mortgage. By getting a home loan instead of using your invested money, you would make between $2.5 to $8.5 million.
Example three, using debt to smooth out cash flow.
- If you are unaware the majority of our expenses are the same every month. You have to pay the same amount of rent, utilities are often the same, insurance cost are the same, and many other large expenses stay the same from month to month. For most individuals with traditional full-time employment, this isn't an issue since they often get paid the same amount every month. For some individuals, this isn't the case. Many people work part-time, or their wages vary seasonally, but their fixed cost like rent does not. These individuals are faced with a challenge. What do they do for the months where income is lower than their expenses?
- The traditional advice would be to build up a reserve from the months with higher income to make up for those with lower income. But this neglects to two important points. What about individuals just starting out who haven't had the time to build up the reserve and what about the time value of money.
- For those individuals who don't have a reserve yet this is the best option. Get a credit card with 0% apr for 12 months and a great points program and use it to bridge the gap. Then pay it off during the seasons of surplus and start investing any extra.
- For those individuals who do have a reserve, I still believe debt is the better option. Like example two, if you have a $6,000 emergency reserve and you know that two months out of the year your income is lower than your expenses. It would be better to use credit to bridge the gap and invest the $6,000 plus any extra you might have. If you did that for five years you could have an extra $2,800 (8% return) to $4,000 (12% return).
The examples above show some wise ways to use debt. But remember debt isn't a one size fits all tool. There are risks, and before you decide to use debt, you need to weigh those risks against the potential rewards. In all of the above examples, your income over a 12 month period is more or at least equal to your expense. If you are in a situation where your expenses are constantly higher then your income, you will need to look long and hard at your expenses to see what can be done. But even more importantly whether you are in a hard financial situation or not you need to be accountable to someone. If your not sure what that might look like check out last weeks blog here.
Debt is a tool. Our culture has done us the disservice of either making us fear debt or making us assume debt is simple and easy to use. Debt as with any tool needs to be used correctly. To do that you need to know what it should be used for. But above everything else you need to allow trusted individuals around you to give you advice and keep you accountable to using it well. I will leave you with this. Debt isn't something to fear and isn't something to use flippantly, but when used properly can be very helpful.