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Reasonable Debt

If you've read some of the other articles on this web site you'd have every reason to think I'm dead set against any debt of any kind. That's not exactly the case, although the notion of being totally debt free has a powerful appeal.

Imagine what it would be like to be completely free of debt. You wouldn't have to procrastinate about paying bills or be grumpy when you do pay them. You could operate on a cash basis and avoid paying out a lot of money in interest expense. You'd be able to pay on the spot for things you need and even some of the things you want but don't really need, and you could make some major strides toward preparing financially for your eventual retirement and other long term goals.

In an ideal world we would all be free of debt and the only payment we'd have to get cranky about would be paying taxes. (Taxes are probably here to stay, and the chances of the tax code becoming both simple and reasonable some day are slim to none.) But we don't live in an ideal world, we live in a real world that is often, maybe usually, less than ideal. We will all probably acquire debt at times during our life journey, so the issue isn't so much an "if" question as it is a "what" question. What sorts of debt are reasonable and make good common sense, and what sorts of debt aren't and don't. There are probably lots of ways to look at this issue, and if you spend some time reading about how to manage your money you'll come across a number of them. However, since I'm the person writing this, I get to express my perspective-so-I will!

I seems to me that one helpful way of thinking about whether a debt funded purchase is reasonable and makes good common financial sense or not is to look at what happens to the value of the item after you buy it.

• Purchases that are likely to increase in value and build your net worth would be reasonable use of debt.
• Things that are consumable and will decrease in value would not be reasonable use of debt.

Now, as with most things is life, the distinction isn't quite as clear and pure as the above statements make it seem. There are some things we genuinely need that will lose value but may cost too much to pay for with cash, and there are some things that could possibly increase in value that we wouldn't want to use debt to purchase. We'll talk a little more about the fuzzy areas a little later.

Examples of things for which using debt clearly seem reasonable include buying a house, paying for your education using student loans, starting or expanding your own business.

1. Buying a house is often the best investment people ever make, and most of us have to use debt to buy one. It's wise to buy one in a good location because the value will increase over time, and it's probably wise to buy one sized for your needs rather than one that is so large and expensive that you have very little money for anything other than house payments.
2. Using student loans to pay for your education makes economic sense because you're investing in yourself and your future earning power. You'll make a lot more money over the years than you would've made without getting your education.
3. Starting or expanding a business you own is reasonable use of debt provided you've done your homework, you have a sound business plan, and you're a good manager. A caveat here is that about 85% of business start ups fail, usually due to inadequate planning and research, not enough funding, poor management, or unwise use of the cash that's in the business.

You get the idea. Things like education, housing, or a business will bring a financial return to you that is greater than the amount of the debt you acquired to get them. These kind of assets appreciate over time rather than depreciate. They don't disappear and they aren't used up.

Examples of purchases for which using loans and credit card debt isn't reasonable include clothing, vacation trips, boats, appliances of various kinds that have a short life span, Starbucks coffee, dinner out, cars, motorcycles, really expensive weddings, art, stereos, television sets.

1. Items that are consumable, like clothing, coffee, dinner out, vacation trips, nights at the theater, are used and gone in a very short time. They don't build your net worth and all you're left with are the payments if you use debt to fund them. A better idea is to save money for these kinds of expenditures and pay in cash.
2. Things like cars, boats, motorcycles, television sets, and stereos depreciate the minute you take them out of the store or off the sales lot and will in no way add to your net worth. Cars could be the exception, within limits at least, and we'll get to that in a minute.
3. Really expensive weddings? Well I've never understood THAT! Why not plan a more modest wedding, paid in cash, and use the difference in cost for a down payment on a house?

As I mentioned above, everything isn't as clear cut as it might seem and there are some fuzzy areas. For example, unless you live in New York City or San Francisco, everybody needs a car these days for a lot of reasons including getting to work so you can earn your paycheck. True, whatever car you get will depreciate as soon as you buy it, but you need one and may need a loan to buy it. So then the issue becomes which car to buy, and it's probably wise to buy something that will meet your needs reliably but isn't terribly expensive. I mean, who needs a $60,000 four hundred horsepower Porsche to drive three miles to work in city traffic everyday? So if you do have to use a loan to buy a car you need, keep it reasonable and affordable. You can always buy your dream car a few years down the road after you've got the rest of your financial house in order.

On the flip side of the coin, there are some kinds of things that could possibly increase in value over time, but don't seem like something you would want to use debt to buy. Art work and antiques come readily to mind. They MAY become more valuable over time, but to use debt to acquire such items isn't a good idea unless you are an expert in the field and you're doing a business in the field. Otherwise buy what appeals to you and pay cash. It is also possible to supplement your own money in buying common stocks by borrowing from your stock brokerage firm-it's called "leverage," another word for debt-with the prospect that the value of your purchase will increase and add to your net worth. For most of us that would not be a reasonable use of debt because of the risk associated with buying stocks. If your stock price goes south, you not only have to make up for loss your own money, you're still on the hook for the borrowed money and your asset has depreciated in value. That process might be OK for an expert professional investor to use, but probably isn't appropriate for most of us.

So, it isn't as if any and all debt is a bad thing, it's just that you have to be careful to manage your debt and limit it as much as possible because too much of the wrong kind of debt is a drag on your finances and limits your options. You have to service the debt before you can do much of anything else. I also think it's always a good idea to look at debt purchases you're thinking about in the framework of an overall individual or family financial plan. The guidance and boundaries your plan gives will help you avoid taking on too much debt.

arley