Influenced by Dave Ramsey, one of my honored students — maybe even a budding PF blogger, who knows? — writes on the horrors of debt. It’s pretty adorable stuff, in its lively and charming youth. The gist of his squib is that all debt is to be avoided, come Hell or high water.
There’s a lot to be said for that point of view. Matter of fact, our friend D. R. White (he of Motivating Minutes) has just published a new book on the topic: How to Get Out of Debt: Using the Internet. He includes the stories of fourteen PF bloggers (full disclosure: one of them is moi) plus ideas and tools to help you plot a course toward a debt-free life. He’s pretty proud of it…so now’s the time to run over to Amazon and grab your copy.
Reflecting on the student’s jeremiad, though, it strikes me that true, full-blown debt-phobia entails a fundamental fallacy: it is not so that all debt is necessarily bad. What is bad is to get so deep in debt that should unforeseen circumstances occur (another recession or economic depression; illness; unemployment; whatEVER), you can’t make the payments.
Some kinds of debt are beneficial, though. For example, even though college tuition is now exorbitant, a typical young person with a bachelor’s degree will earn almost a million dollars, over a lifetime, more than a typical young person with a high-school diploma. Even after college loan debt and taxation are subtracted, the college graduate’s net gain amounts to hundreds of thousands of dollars.
The typical American college graduate ends up with a relatively small student loan: about 30 grand. While that’s not pleasant, it’s actually about what a late-model car costs. Most people can pay off a car loan in five years. BUT the difference between a college loan and a car loan is that the college degree APPRECIATES over time (returning many thousands of dollars in enhanced earning power) while a car DEPRECIATES over time.
The college loan returns cash to the borrower and buys an asset that lasts a lifetime. The car loan takes money way from the borrower and leaves behind a devalued asset.
In effect, the college loan leverages debt to the borrower’s advantage. The car loan works to the borrower’s disadvantage. Thus one could argue that some kinds of debt actually benefit the borrower while other kinds work against him or her. The challenge is to identify what kinds of debt are worth taking on and what kinds represent a threat to your financial well being.
Similarly, a mortgage on a fairly priced house (not one whose value has been inflated during a “bubble”) may work to some people’s advantage. If you are earning money and investing it in a 401(k) or other type of fund, in an economy such as the one we’re in now, your investment returns about 9 percent. But today’s mortgage rates are still under 4 percent.
So, instead of paying off the mortgage, you’re better off to invest the amount in securities, which at this time are returning about 5% more than you would “gain” by throwing your money at the mortgage debt. Here, too, you leverage money to your advantage: you have to have a roof over your head, and the low-interest loan makes it possible to have your cake and eat it, too.
On the other hand, credit-card debt is usually disadvantageous, because most of it goes to buy material things that often are not needed at all. A television set, a closetful of clothing, a hundred dollars worth of fancy department-store make-up, a comic-book collection, a new computer game , a restaurant meal: none of these things appreciate in value or make it possible for you to build wealth. Thus this type of debt represents a drag on your financial well being.
These are important distinctions. They point to the fact that people need to have some financial sophistication to thrive in today’s extremely complex economy.
A loan that allows you to earn more or save more can be said to be “smart” debt. One that takes money out of your pocket and returns nothing of real value — well. Not so much.