Why Good Debt is a Truth

I’m a big fan of Squawkfox and her blog. Although always entertaining, she’s not always right (alas, I seem to be the only one who can manage that). In a recent exchange I cited her wonderful article on debt as an example of something well-written that I enjoyed reading, even though I disagree with it. She challenged me to write a rebuttal (go read her article first, this will make more sense afterwards). So, given that she likes smart men who disagree with her (I may not be able to manage the smart part, but I can make the most out of disagreeing with her), here’s my first attempt at stealing her away from her organic farming hubby (with his bulging biceps and green sensibilities: as if any woman would be into *THAT*).

To take a step back and get philosophical, debt and investment can be viewed as parts of a continuum of resource consumption. If we consume more than we produce, we incur debt: using resources before we earn them (which further restricts incoming resources, as a portion must be diverted to repay debts). If we produce more than we consume, we can invest the excess: delaying consumption of resources (which further increases incoming resources). In the middle is the person living paycheck-to-paycheck, staying out of debt (but always spending everything they earn). There is an interesting compounding effect that it gets easier to move away from the center the further you get from it (with Warren Buffet on one end and guys like Casey Serin or Debt Kid on the other).

The devil is in the details, as they say, and nuanced elements of this model can (and are) picked to death.

From this perspective, as Squawkfox advocates, it is easy to take the position that debt is bad, and investing is good. I want to be like Warren Buffet and not Casey Serin! Everyone can agree that bad debt (such as buying consumer goods on credit card or using your line of credit to go on a trip to Hawaii) is a situation to be avoided.

Where the model falls apart is that it *is* possible to borrow resources (go into debt) to increase your incoming resources MORE THAN the cost of borrowing. This is the idea behind the much misused idea of “good debt”. At it’s simplest, if you borrow money at 5%, invest it at 10% and pay back the debt with half the investment returns you’re in a good position to make some significant returns. Where the get-rich-quick crowd glosses over the details is when the 10% is a risky, speculative investment (but they still call it “good debt”) that will leave you with a massive debt (even if it’s at 5%) with no way to repay it, other than trudging off to work every day. It works out great if you’re lucky and it works out, but you’re up the creek without a paddle if something goes wrong.

HOWEVER, there are things you can borrow money for which have very low risk and a good chance of paying back far more than the interest rate of the debt. This is what “good debt” means to me, and it’s very real. The Fox hits a number of these and I’ll answer each in turn why I think they ARE good debt, even if she doesn’t.

1. Student Debt

Squawkfox presents two examples of when student debt is bad debt: studying a program that won’t help you improve your employability / expected income & overspending during your period of study. I agree with her on both of these issues. You should carefully consider the job prospects after graduation, and if they’re low for your chosen course of study, consider something more practical and keep the other interest as a hobby. If you can live cheaper (or work) while at school and graduate with less debt, of course this is a good idea.

HOWEVER, as the Fox and I have both experienced studying computer science, it gives access to jobs that MORE THAN repay the cost of education. This makes it good debt. Squawkfox repaid $17k in student debt in 6 months (point number 1 is key, in my opinion), which would have been almost impossible working a minimum wage job. There is still risk involved (I don’t think either of us is actually employed based on our CS degrees right now), but if the right degree is chosen, it has a very good chance of paying back far more than the cost of tuition and living expenses.

The US Census Bureau estimates that, over a lifetime, a high school diploma is worth $1.2 million, a bachelor’s degree, $2.1 million and a master’s degree, $2.5 million. You can debate their methodology (probably with other university grads), but it would have to be a VERY expensive school for 4 years of your life (and associated expenses) not to be worth almost a million dollars.

Not all student debt is good debt, but some of it is.

2. Mortgage Debt

The buy vs. rent debate has been going on forever (and I won’t try to settle it here). Squawkfox makes EXCELLENT points here, and I definitely don’t think all mortgages are good debt. That being said, some are. If you compare the TOTAL expense of ownership and the rent saved to the expense of renting (and the opportunity cost of not investing the savings in a diversified index fund) this tells you if your mortgage debt is good debt or bad debt.

3. Business Debt

Business debt is a very complex, and I won’t try to cover any of it here (Preet or Thicken My Wallet could do a far better job than I). The Fox mentions that many people don’t have the know-how to run a business profitably and will just drive themselves into debt for nothing. She’s right, that for THESE PEOPLE, business debt is bad debt.

For someone who DOES know how to operate a business, they can generate a better return from the business than what they pay to borrow capital, and this is good debt. A friend of mine is dating a guy who runs a Subway. He loves the business and has tons of marketing ideas, but the owner is happy with the status quo and isn’t interested. I’ve encouraged her to encourage him to buy his own franchise (he would have to borrow money to do so). He’s already demonstrated that he has the interest and aptitude to run the place. If he’s going to devote a good portion of his life to doing so (which he already is), why not buy the franchise and benefit himself instead of the hands-off owner? There is some risk (there are bad franchises, you’d have to do your research – I’d start by talking to a number of current franchisees, and NOT the ones the company refers you to), and even good franchises can turn bad, but I think the expected return for him would be higher (even factoring in the cost of borrowing) than being an employee manager for the next decade.

Sometimes it’s possible to get non-recourse investments in your business (people lend the business money that you aren’t personally liable for). This is GREAT debt, as you’re passing a lot of the risk of business failure on to your investors (who should be big boys / girls who understand the risks – don’t do this to scam people who don’t understand what they’re investing in). At the same time you’re keeping a lot of the upside for yourself.

4. Health Debt

Different people respond differently to stresses, and debt really knocked the Fox down. This is totally fair (and power to her if she avoids it for this reason alone). My mother can’t handle the gyrations of the stock market and so she keeps her money in GICs. This is the best thing for her. She’s lost potential gains over the years, but she can sleep at night (which is priceless) and can more than afford her retirement lifestyle. Perhaps for the Fox all debt is bad debt.

I’ve been debt free most of my life. In late 2006 I went into serious debt for the first time to buy a condo. The condo has paid for itself (income exceeds expenses) and has tentatively increased in value (I won’t know for sure until I sell) by about $30k. I felt the slightest twinge of unease when I was signing the mortgage documents (apparently this is typical for property virgins), and it hasn’t bothered me in the slightest since.

I started leveraging my stock account, buying dividend paying blue chip stocks (ala Derek Foster). This has been a disaster (my investment in Bank of America is down 67% and magnified my loses in a major market downturn). I knew the risks when I started doing it, and made sure it was small enough amounts that I was able to cover any margin calls. I haven’t lost any sleep over these investments. I’ve been deleveraging (mostly because I’m a low income student now), but I’d have no problem following the same strategy in the future (I wish I could be doing it right now with the current markets).

For me, these debts were good debts (from a mental health perspective).

5. Conclusions on Debt

I’m happy for the Fox if she’s happy to be debt free. Much like my mother avoiding the stock market, I think she’s paying a price to avoid debt. That being said, it sounds like she’s thought it through and has good reasons why that is right FOR HER. For other people, such as myself, going into debt has been a very worthwhile way to gain access to investments (such as investment real estate) or to construct investment vehicles (such as my leveraged stock portfolios) that would be effective in a different market environment.

So there’s my rebuttal. Squawkfox: Get in touch with me when you get sick of your husband! 🙂 Until then, I’ll be making kissy faces to your about page picture and admiring my framed pictures of your underwear.