Financial Mathematics Text

Wednesday, May 1, 2013

On the Use and Abuse of Debt

Debt plays an important role in the US economy (and the world economy for that matter). It's actually a very interesting social arrangement. I highly recommend David Graeber's book - Debt: The First 5,000 Years - if you're interested in exploring debt from an historical/anthropological perspective.(I may discuss this in a later post if I get around to it.)

Today I won't be questioning the existence of debt relations but will take them as given. The question here will be this: is there a sensible way to deal with debt?

There seem to be two extremes in the US. On the one hand, you have a minority that follow what I'll call the Dave Ramsey approach: debt is bad and you need to get rid of it. Frankly, I think it's a far more sensible approach than the vast majority of citizens in the US take which is the other extreme: borrow until you can't borrow any more and then borrow some more!

I'd like to suggest that there's a "middle path" to all of this and I want to spell it out. I think it can be summed up by asking the following question:

How will the asset which is being financed with debt be able to pay off that debt? 

If you can't answer that question, that's a good indication that you shouldn't borrow money to make the purchase you're making.

This criterion is actually quite flexible though which I will attempt to show.

There are basically two factors to consider:
  1. How does the asset pay you money?
  2. Is the return on the asset greater than the borrowing cost?

Many assets that are financed with debt aren't going to pay you money. However, some will result in lower expenses. Those assets might be sensible assets to finance with debt (within reason). We'll take a look at some examples to illustrate.
  • Houses - The reality of the matter is that you need to live somewhere. So it's a choice between renting or buying (and taking on a mortgage). So buying a house will pick up some additional expenses while eliminate other expenses.

    There are advantages and disadvantages to buying versus renting. Those all need to be factored in. But purchasing a home with a mortgage can be a sensible use of debt. The key is to not pay too much for the house.

    As a discussed in Is Housing an Investment?, it's important to compare house prices with renting and see what costs you're saving and which ones you're picking up. Then pay a sensible price for the house.
  • Cars - Realistically, cars are a horrible investments. They lose value as soon as you take them off the lot.

    That said, for many they are essential to insuring that one can get to work regularly and on time. And that's critical for a regular paycheck.

    So while your car isn't likely to produce any cash for you, a lack of a car may result in lack of income. So I think it can make sense to finance a car but I think being conservative here is appropriate. To get to work on time you don't need a brand new vehicle; anything that can reliably to get you from point A to point B will suffice.
  • Education -This one is common to finance and many are speculating about a "student loan bubble". While I think there is reasonable concern here, the fact still remains that people with a piece of paper (degree) earn more money than those that don't.

    Value of College Degree

    So even if we ignore the other (non-financial) value to an education, it still may make sense to finance an education provided the cost is below the present value of excess income. (For why Ivy league business degrees may not be worth it, see here.)

  • Big Screen TV - Sometimes big ticket items like a large screen TV are financed with debt (and sometimes with credit card debt at the tune of 20-30% interest). This one doesn't make much sense financially speaking.

    While a new TV may save on energy costs, this will likely only amount to about $10, hardly enough to justify the purchase with debt. And having a new TV may incline one to spend less on other entertainment, but that probably won't offset the significant cost of financing such a TV with debt.
Now there are plenty of more examples. But the point here is that, at a bare minimum, the asset you purchase should have some capacity to generate income or reduce expenses.

No comments:

Post a Comment

Some common OpenID URLs (no change to URL required):