Last week we featured one of our favorite videos about the economic machine in which Ray Dalio, founder of Bridgewater Associates, talks about how the economy is transaction based. At one point in the video he discusses the use of debt in our economy, noting the difference between using debt to purchase farming equipment and using debt to purchase a flat-screen TV. He points out that the farming equipment will allow the farmer to grow more crops, thereby allowing him to earn more money, increasing his income in addition to providing extra money to pay off the interest on his debt as well as the debt itself. On the other hand, the big screen TV will not make its owner any additional money such that if the buyer does not have the money to buy the TV not only will he not be able to repay his debt, but he won’t have the money to pay the additional interest and will have to borrow even more, launching a vicious cycle of growing debt that can quickly snowball out of control.
Not all debt is bad, but it is often misused. We live in an age where debt is plentiful. In fact, the bond market, which is, in essence, a market of borrowing, is the largest market in terms of asset class type. You can borrow money to buy a new car or a home. You can borrow money to finance a new business idea or to go to college. Every time you swipe your credit card you are borrowing money to purchase something. Debt is everywhere and while it has opened up a world of opportunities to us, it has also caused us to find ourselves in a world full of hurt. If you’re at all familiar with the stock market then you probably remember the financial collapse of 2008, which was caused by a variety of different factors, including debt. Simply put: individuals borrowed large sums of money that they couldn’t pay back causing them to default in very large numbers causing our economy to tank (a bunch of other stuff happened that made it worse, but that's an article for another day). This was an instance where debt was bad. But not all debt is bad. So when is it good?
The concept of borrowing goes way back. There are biblical proverbs and ancient stories about borrowing. Borrowing was initially meant to be used as a way for one individual to grow his (or her) wealth by lending some of it to another person to “invest” in such a way that they made enough money to pocket some and then pay back the loan plus a little (interest). The key word here is invest. Investing implies that there will be a return on the money that you put up; that your investment will grow. The growth is crucial to making debt worthwhile. Consider two examples:
Example 1: Let’s say that you own a retail shop. Your shop is doing well, but you’d like to grow and think that given the demand for your products, you could easily do so with a small infusion of capital. Unfortunately, you yourself don’t have the savings to inject into your company. You currently sell about $500 in merchandise each day, which goes right back into paying your employees and buying new merchandise. However, you could borrow money to buy even more merchandise and in doing so increase your sales so much so that you are able to pay back the loan with interest and still pocket a significant amount of the additional income. You have used the debt to grow your business, pay off your debt, and ultimately increase your income. This is great news! You have used debt in a good way.
Example 2: Let’s say that you love to shop. Each month you have $100 to spend on new purchases. This month, however, you’d really like to spend more so you borrow $1,000 and go on a crazy shopping spree. When all is said and done, you spend the entire sum that you borrowed, but now the lender wants you to pay them back with interest. Unfortunately, not only do you not have the money to pay them back, you also didn’t make any money to cover the interest. Now you have to borrow more money to pay off the money you owe which raises the amount of interest you’re being charged catapulting you into a cycle of ongoing debt. This is terrible news. You have used debt in a bad way.
Today, the use of debt helps us grow the economic pie by providing capital to individuals with smart business ideas who are lacking the money themselves to launch their ideas into the marketplace. By lending and borrowing, we increase the opportunities to make more money, which leaves both the lender and the borrower better off. Where we find ourselves in trouble is when we lend money to a poor idea that isn’t likely to pan out and when we borrow for something that isn’t going to earn money. Things like new clothing, fun electronics, vacations, and weddings don’t earn money and it’s a bad idea to borrow money to pay for those things. There are of course exceptions to this rule – say for instance putting those things on a credit card to get the rewards, as long as you pay that credit card off immediately instead of allowing that debt to accumulate interest. Remember, if your purchase isn’t earning money then it isn’t going to pay for that interest. On the flip side, investing in a home that has the potential to appreciate in value or an education that has the potential to get you a significantly better-paying job can be good uses of debt (so long as the earnings potential outweighs the cost of the debt). In any decision regarding debt, it pays to do your research and understand the math. Always ask yourself how you're going to pay that debt off before you borrow it and make sure you're being realistic with yourself.
Salespeople are great at convincing you that what they're trying to sell you will "pay for itself" in x amount of years when in reality, you aren't actually going to set aside the money you're "saving" to pay off the money you borrowed to buy that item in the first place. When it comes to real estate - do your homework on what investments do add value and what type of appreciation you can expect. Making updates to your home that are specific to your personal tastes shouldn't be considered "investments" unless your tastes are also shared by other potential buyers willing to pay more for those updates. Similarly, before taking out money to go back to school, make sure you understand what the money will cost in the long run and the likelihood of getting a raise in your income from earning that degree to pay off that student loan. If you’d like to learn more about how to manage debt and plan for the future, feel free to check out some of our other articles or give one of our advisors a call today!