The Ethics of Debt
There is much debate about debt and how it fits into a financial plan. Depending on whom you listen to, you may have an impression that all debt is equal.
Robert Kiyosaki, the author of the Rich Dad Poor Dad empire, has never met a loan he didn’t like. In fact, he’s been on record advising to take out as large a real estate loan as the bank will give you and if you are saving your money you are stupid. Kiyosaki’s leveraged wealth creation approach has helped many improve their financial situation, albeit at considerable risk.
Compare that to the radio and media juggernaut Dave Ramsey, who lies on the extreme opposite end of the spectrum. Preaching that all debt is wrong, Ramsey associates religious morality with getting out of debt. Ramsey’s debt avoidance approach has also helped millions significantly improve their financial situation, even with a significant opportunity cost to both their wealth and lifestyle.
Both of these men have small amounts of genius at the foundation of their message and are worth listening to. Unfortunately, the extreme positions they take don’t account for the nuance and complexity needed to most effectively manage money in today’s society.
The truth of the ‘ethics’ of debt is found somewhere in the middle.
Debt is neither something to be pursued nor is it something to be afraid of. Debt is a tool in financial management, and a very powerful and useful tool. But that doesn't mean all debt is good. In order for a loan to be considered good, it must improve your financial situation.
Despite the fact debt increases your financial risk and costs you money each year in the form of interest, not all debt is bad. By calculating your future financial position after the debt, that is the amount your assets and cash flows will have increased as a result of the loan, you can determine if the loan is worth the interest cost and risk it creates.
Although doing math doesn't sound like fun, proper debt management and financial management requires you to understand the true cost and benefit of any decision. Fortunately, you can avoid having to do the calculations on many loan decisions by first applying an initial litmus test. Good debt either directly purchases an appreciating asset, creates or increases an income stream, or keeps you alive. If the debt doesn't fall into these three categories, don't bother doing the calculation because it isn't good debt.
Categories of Good Debt
The three categories listed above (appreciating assets, income streams, and health) are the only three reasons anyone should own debt. In all three cases, the common theme is you are left in a better financial situation after the loan than you had before the loan.
Appreciating assets are assets which increase in value over time. The most common loan in this category is your mortgage loan. It is hard to argue with the wealth creation power of home ownership. And those who say they got wealthy without debt conveniently forget it was a loan which allowed them to buy their most valuable asset.
Twenty years after you’ve purchased the house the value will have doubled, but the loan payment will have stayed the same. And with inflation, the mortgage bill will slowly become an insignificant portion of your monthly income. Anytime you purchase an appreciating asset with debt, you have the potential for profit if the appreciation is greater than the interest cost.
Debt which increases your income stream can include loans used to finance rental property or start a business. Both of these are also appreciating assets, but the real benefit is the cash flow they create because cash flow can be used to offset or completely pay the loan costs.
The most common income-increasing loans are student loans taken out to improve long-term earning potential. If the loan is small enough so the income it creates or adds is greater than the total cost of the debt, then you will have improved your financial stability by taking out the loan.
Finally, debt for medical bills to help you stay alive can only be viewed as good debt. If your choice is taking out a loan or dying, the loan is the preferred option. Although there are much better ways to handle medical emergencies, such as health insurance and savings, you aren’t going to improve your financial situation very much if you’re dead.
Debt as a Tool
The main purpose of debt is to move money around in time. When you take a loan out, you are sending money you are going to earn in the future back in time to the present day. With the money in the present day, you can use it to purchase homes, cars, vacations, or video games. Obviously not all of these would be good uses of debt, but you can use the money in any way you want.
Of course, the money was your money from the future. As a result, when the future comes you’ll have to send money ‘back in time’ by paying off the debt. The fuel for this time machine being the interest charges.
Viewing debt as a tool will help you to have a healthy respect of it without being afraid of it. Fire is probably mankind’s greatest tool. It cooks food so we can eat it more safely, keeps us warm in the winter, provides light so we can work in the dark, and keeps wild animals at bay. It can also burn your house down.
Too Much of a Good Thing
When you take on too much debt what you are really doing is sending too much of your future money back in time, leaving you in a difficult future position. A drink of water is refreshing on a hot day and is required to stay alive. Too much water, however, and you will drown.
Debt to buy a home is definitely a positive thing for your financial situation, but if the debt allows you to purchase more of a home than your future earnings can truly afford, the result is disastrous. Millions of families found this out during the financial crisis of 2008 when they couldn’t afford the homes they purchased.
There is no magic number for how much ‘good’ debt is OK; a baby can drown in an inch of water, after all. The question is how capable your income and finances are of handling the amount of debt and the associated interest cost and payments.
Bad debt is everything else. Honestly, we are done with this section and no need to provide an exhaustive list of bad debt. There is no other debt which improves your financial situation. Credit card debt, boat or other recreational vehicle loans, or loans to finance a wedding or a vacation all place you in a worse financial situation than before you had the loan.
If you need a car to get to work, then you can take out a loan to buy a car capable of taking you to work, but most people buy far more car than they need. My wife and I currently (2017) have auto loans for our cars, but we also have the ability to transfer money from a savings account to pay off the loans in full if we wanted.
We do this so we can use the money for other more beneficial purposes, which improve our financial situation more than the cost of the interest. Before embarking on a strategy such as this, however, you should seek the advice of a professional financial planner.
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Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at firstname.lastname@example.org