In my principles post I stated my stance on debt. This stance hasn’t changed but I thought I’d expand on it further.
I also weave in some of (…actually a lot of) Ray Dalio’s ideas on debt. I think he articulates debt better than anyone else in the media.
In short, I think debt is an advanced finance tool. It’s not for 18-year olds to run around and rack up balances with 20 percent interest. My general advice is that if you don’t understand basic finance, business, investing, etc., then debt is just a four-letter word that is to be avoided at all costs.
However, for those that have their act together, debt can be used as a tool.
Regardless of how you take on debt, having a heads up, conscious mindset as to why you’re doing what you’re doing, how long you’ll be incurring your debt and when you’ll get out of it is what’s important here.
By having your act together, I don’t mean you just read the Millionaire Next Door or Simple Path to Wealth. Rather you’ve read these books or ones like them and have applied their teachings over a span of time such that you can show that you can live your life in a financial surplus and be responsible.
Enough preaching, let’s get started…
Types of Debt
Credit goes to Ray Dalio the billionaire hedge fund manager for the first three types of debt in this action. The 4thtype, emergency debt, is my addition.
As I stated above, these are what I would consider advanced topics only for those that understand money and have shown financial responsibility over some span of time.
Consumer Debt
The first type of debt and the debt most are familiar with is consumer debt. Credit card debt, in-store financing, pawn shops…this debt comes in a few different forms.
Consumer debt should be avoided altogether.
It doesn’t generate income or boost savings, and in fact it does the opposite. Someone is making upwards of 18 percent interest on YOU when you have consumer debt. You should be making that 18 percent in your investments somewhere else.
Consumer debt is like a tax on the financial illiterate.
That $500 HD TV can be broken down to $10 payments over 5 years at only 6% interest. Heck I can afford $9.67 a month!
Don’t fall for it. Think about what you really need and focus on that. If you don’t have the money, save.
In case you missed this point, consumer debt consumes the consumer and should be avoided at all costs.
Debt that boosts savings
This is probably a little controversial for some, but you can consider a mortgage as a type of debt that boosts savings.
If you take out a simple 30-year conventional mortgage, you’ll be paying off that mortgage at a relatively low interest rate, while (hopefully) the value of the property increases overtime. You can then sell that property and make money down the road.
Unlike the $500 HD TV example, at the end of the loan you’ll have an asset you can sell for more than what you paid.
Ray Dalio refers to this as “forced savings”. You’re forced to pay off the mortgage on that appreciating asset or else the bank will take your house!
I point out the controversy in this because a lot of people will break out their spreadsheets and show how you can do so much better investing in other things (stocks, real estate, your own business) and have better returns.
I’d just point out that (1) this actually worked for me so I can say it’s valid, and (2) yes you can demonstrate through some spreadsheet arithmetic that other investments can be more profitable, but that all depends on your acumen as an investor, whether or not you pick the right or wrong investments, and even then know what to do with them.
Debt that generates income
This is the most ideal use of debt. This is where you can use debt as a tool to get what you want or to get to the next level.
A classic example is the American farmer. He buys a tractor which in turn works to generate income to pay off his debt.
Perhaps a more modern example would be if you have your own gift card business. You design and sell gift cards. You take your design to a printer and they print and ship them out to your customers. Eventually your business grows to the point where you realize that if you buy your own high-end printer you can print and ship yourself and increase your profit margin. You buy that printer on a loan and over time your revenue from your business goes toward paying off that debt.
There you have it. Classic American entrepreneur example of taking on debt to start or enhance a business. In addition to using the revenue generated by the printer to pay down the debt, you can also amortize the printer over time, further benefiting your business.
Emergency Debt
This is my addition as a type of debt. This is the ‘oh shit I didn’t see that coming’ debt.
Major medical, property damage, or possibly a lawsuit. No one wakes up in the morning and thinks they’re about to take on a $500,000 liability that will plague them for years. But it happens.
The point of bringing up emergency debt is twofold. First, it covers all bases on types of debt. There’s impulsive consumer debt, there’s debt that can increase your savings and there’s debt that generates income. I think emergency debt should be a separate category in and of itself because it’s not impulsive or deliberate like the other types of debt, it’s just life happening.
Second, the idea of contemplating emergency debt is important because you can take steps to mitigate it. That is, you can envision the types of emergencies that can befall you and research the proper type and amount of insurance that is needed.
Medical insurance, car insurance and either homeowners or renter’s insurance are the first things that come to my mind. Then there are different types of life insurance. Once you reach a net worth of $500,000 or more, umbrella insurance should come into the picture. Yes, that is a lot of insurance one can hold, but when you start having a high net worth ($500,000 is a lot of money) it’s worth it to protect that hard-earned wealth.
Emergency debt should be consciously considered for anyone especially for folks starting out on their FI journey.
Good and Bad Debt
Suze Orman was famous for using the phrases good debt and bad debt. I get it and all, but I’d recommend against even thinking of debt this way. It’s not good or bad, it’s a tool, or in the case of consumer debt, it’s a ball and chain.
Instead of thinking of debt as good or bad, I’d rather see it as a tool to get from point A to point B, like taking my business to the next level.
Questions to ask before assuming debt
There’s nothing like the power of questions to force you to re-think your ideas. Here are a couple of questions you can ask yourself before taking on debt.
- Will this debt allow me to earn more money?
- How will I be better off once I pay off this debt?
- Will I be wealthier in the future as a result of this debt?
- Do I have a clear exit strategy to get out of this debt?
Exit Strategy
An exit strategy is critical no matter what type of debt you assume. The exit strategy is planned before you fill out that form and take on your first payment.
I recommend the mortgage professor mortgage payoff spreadsheet. It can be easily changed for mortgages, cars, or anything else. Just enter in the amount financed, the down payment, the interest rate and term, and the spreadsheet does the simple arithmetic to calculate what the debt payments will be, how much interest you will pay, and when you’ll have it paid off. It includes a column for extra payments as well so you can experiment with extra payments to pay off the debt early. I used this same spreadsheet to model how I paid off my mortgage and it worked great.
Debt and the FI Lifestyle
I am writing this post from my personal experience.
When I carried debt in the past, either mortgage debt or car payment debt, I wasn’t necessarily thinking of FI anytime soon. I personally found it tough to think about walking away from the 9 to 5 while still making debt installments.
When my wife and I paid off our last remaining debt, our mortgage, we weren’t exactly ready for retirement at that point in time, but it was a huge step in that direction.
After about a year of being debt free, saving and investing more money (since we had no mortgage payment) we were finally able to see FI a lot more clearly. That clarity was not there when we had a mortgage payment.
I guess you can say that carrying debt clouded the FI vision. With it, FI was far away and uncertain, without debt FI was a lot clearer.
This post may seem fundamental to many but thinking about debt in different ways should challenge you to think more carefully about what you’re doing when you are considering a loan.
In closing, debt is a tool that should be used carefully. If not, it’ll shackle you and keep you from crossing the FI finish line.