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.
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.