When you borrow, you should know exactly how you'll pay it back.
Credit = Debt = Liabilities
The primary reason for debt to exists as a tool is to increase your purchasing power, meaning you can buy more than you can afford, with the promise of paying it back later (with interest).
The issue with debt is simply too many folks use it incorrectly, and end up locking themselves into debt/spending cycles, or just drastically having to restrict their lives and personal mobility, simply because they need to repay the debt and interest back. We’ve seen this behavioral symptom exaggerated during the housing bubble, and we are seeing it now with student loans, auto loans, and credit cards. On an individual basis, things happen, and sometimes individuals are unable to repay back their debts, however, when this behavior happens on a societal level, anyone with the slightest sense of responsibility must stop and ask: what’s wrong with this picture?
There is no question that financial institutions at various scales abuse consumers by tricking and trapping them in debt cycles. But that is frankly a topic for an entirely other site. We are here to discuss personal finance, and so, let’s re-focus our attention on the individual responsibility of a borrower.
So, what’s the point of a loan? Why take on debt in the first place?
Referencing the financial statements once more, Liabilities are part of The Balance Sheet. Their counter points are Assets. Debt and Assets are linked. Debt, in a perfect world, should be used ONLY to develop and acquire assets. Converting a loan into a productive asset is a beautiful thing, it’s like magic, honestly. Take this example into consideration: one puts up 10-20% of the value of a house down, borrow the remaining 80-90% from the bank, rents the house out to tenants, eventually repays the loan, positive cashflow and 100% of the asset is theirs, magic. However, in our society debt is used more often then not as part of the P&L (i.e. not The Balance Sheet). This means debt is used for expenses, and this is the source of so many financial problems. Once the money is spent there is nothing material in place to pay it back, and so, the borrower is left in a position where they either need to sell more of their time, or cut their spending in order to make up the difference to pay back the debt. This is an absolutely brutal paradigm, and is far from magic, it is in many cases a nightmare for the individual borrower.
Here are a couple of illustrations expressing the state of American borrowers. Let’s start with an overview:
* Source: Federal Reserve Bank of Philadelphia
Consumer debt has certainly grown relative to mortgages, but this doesn’t begin to scratch the surface yet. Lets look at total consumer debt, then total consumer debt across the entire population, then total debt between total borrowers:
Since housing debt can clearly be considered a Balance Sheet linked debt (i.e. an Asset), let’s zoom in closer at debt as an expense category (i.e. these are the categories that produce ‘debt-slaves’):
The major culprits where abuse is taking place outside of the balance sheet can now be seen as clear as day:
Student Loans: in the case of student loans, an argument can certainly be made that since the loan is used to increase the value of the individual in the marketplace, and that by taking the loan to pay for their education they are able to repay it with greater certainty be adding skills the market values that this loan is justified. While this is a valid argument, what happens if the individual decides to add skill that aren’t valued by the market? What if instead of studying computer science, said individual studies french literature? What that loan worth it? Should the university have charged that amount for admission to begin with? Should everyone get a degree? If so, for what reason and for what price?
Auto Loans: these loans are much more straight forward. Money is borrowed to purchase a vehicle. The vehicle is used for collateral. However, unlike real-estate, cars do not appreciate in value over time. Moreover, it is common knowledge that the value of a brand new car can drop by up to 30% upon simply driving out of the dealership. Auto loans can be very dangerous for many borrowers. Truthfully, unless one uses this type of loan as a cashflow strategy, or for business, then it is basically a lifestyle purchase, which entraps the borrower in a debt cycle and a depreciating asset. Auto loans defaults are at an all time high today (2019), and many are predicting the “bubble” on these loans will burst. If you need a car, buy a clunker until you can actually afford the vehicle you want. Or better yet, if you can use public transportation or share vehicles, just do that, it will save you in the long term.
Credit Cards: this is a sensitive subject for many Americans. We’re all taught to use credit cards regularly, “they boost your credit score”, “'it’s good to carry a balance any pay some interest on it”, “I just transfer my debt from credit card to credit card when the interest is too high”. These are all common practices. And with credit card offers pouring into our mailboxes, it is no real surprise that so many American have misused credit incorrectly. While credit cards can be wonderful tools when it comes to amassing perks from banks, as well as layering another level of security between your bank account and the merchants you interact with, these tools should be uses correctly. The balance should always be paid off in full (i.e. do not carry even a single $1). Use credit cards as debit cards, and always make sure you have the funds to cover the cost.
4 Types of Debt
Generally and broadly speaking there are only four types of debt, while there are a myriad of loans available to consumers. What constitutes wether a debt is “good or bad”, depends on your strategy in using it, and in how it is serving your financial needs via ultimately increasing assets and cashflow. So what are the different types of leverage one can use?
Mortgages: The majority of consumer debt is held in the form of mortgages. They are used to secure the largest asset most individuals own, their home. Mortgages can also be used as investment opportunities, by purchasing investment properties.
Secured Debt: Mortgages and Auto loans are a forms of secured debt. Let’s say you need a loan to buy a car, the lender supplies you with the cash necessary to purchase the vehicle but also places a lien (i.e. a claim of ownership) on the vehicle's title. In the event you fail to make payments to the lender, it can repossess the car and sell it to recoup the funds.
Unsecured Debt: Credit Cards, signature loans, gym memberships, and medical bills are all forms of unsecured debt. There is no collateral to guarantee the loan, and so these are considered a higher risk for the lender. The general result of this higher risk is a higher interest rate for the borrower.
Revolving Debt: Credit Cards & Lines of Credit are revolving in nature. Revolving debt is an agreement made between a lender and consumer that enables the consumer to borrow an amount up to a maximum limit on a recurring basis.
On the topic of debt repayment. As mentioned above, we strongly recommend you have a clean plan for repayment before the debt is even assumed. However, not everyone is ahead of the curve when it comes to this topic. There are 2 primary strategies for debt repayment. One is rooted in savings percentage, the other in behavioral psychology. We’ll call them the Interest Attack Strategy and The Snowball Strategy.
The Avalanche Strategy: this one makes the most sense financially. Make a minimum payment on all your accounts and then target the account with the highest interest rate first until it is completely gone. Then move to the next one in line until all the debt is wiped out.
The Snowball Strategy: this one taps into our psychology by eliminating the debt with the smallest amount owed fist, thus providing us with some dopamine upon the quick completion of the debt repayment, theoretically incentivizing us to keep going.
Here’s one scenario: you are completely debt free, your income is steady, you’ve got some assets, you have a handle on your investments and/or a clear investment plan, and you are pretty much in control of your finances. This is the position you want to be in when assuming debt, in control, at this point you have earned the right to start using debt/leverage as a tool with out risking financial instability. Remember that debt is designed to increase purchasing power, and should be contained within the balance sheet, meaning one should use debt to acquire productive assets.
*DO NOT increase your buying power to acquire a lifestyle, and or support your spending habits.
The concept of infinite profit illustrates the beauty and power of debt as a productive financial instrument.
Infinite profit, simply put:
If I invest $1, and I make $1, that’s a balanced model
but, if I invest $0, and I make $1, then that’s infinite profit.
This is what often happens with seasoned real estate investors, banks give them extremely low interest loans, the investors purchase assets with said loans, and have the renters return the debt to the bank until they fully own the asset and now have all that income generated regularly. Infinite profit.
Now that you've wrapped your head around all that, you can begin to see how you could use credit productively in your own life.
FPF EXERCISE: USING CREDIT
When you are ready to use leverage to increase your purchasing power, ask yourself these questions and answer in detail before borrowing:
If I take out a loan what is it for and how will it contribute to my investment plan? How can I use it to increase my cashflow?
Am I taking the loan out of desperation or is this a calculated move?
How long will it take me to pay it back? What are the terms exactly?
What is the upside? How much will I be making by using this loan?
How will I be converting this liability into a valuable asset?
What are the fees and percentages attached to this debt?
Choose your lenders carefully and build relationships with them! You do not want to take a loan from simply anyone.
Food for thought:
Legendary Ray Dalio explains his machine model for the economy