A more sophisticated way to think about debt
The notion of “good debt” versus “bad debt” is probably familiar to you. Many personal finance authors and speakers use this concept to distinguish between high-interest credit card debt and more sustainable mortgage debt.
The gurus’ underlying message is that you should strive to rid yourself of any and all debt. Authors and speakers Dave Ramsey and Suze Orman are prominent torchbearers for this message.
“Ultimately,” Orman says, “the goal of retirement is to become as debt‐free as possible.”
There’s a more nuanced idea of debt than the picture conveyed by the Ramseys and Ormans of the world. Debt itself is not good or bad. Debt runs along a spectrum that includes different types and varying levels.
Too many people are either way too highly leveraged or are completely debt-averse.
There is an ideal middle ground -- but too few people find themselves in that optimal zone. The few individuals who do happen to fall in the sweet spot are there by sheer luck rather than strategic choice.
Imagine the CFO of a major company hopping on an investor call and saying, “Hey, what do you think about our debt structure? I took a guess at it!” That would never happen. Companies proactively choose an optimal debt structure. You can and should do the same.
Three types of debt
Rather than breaking debt down into good or bad, here are three categories that will help you think about debt:
Oppressive debt. Avoid this type of debt at all costs. As the name indicates, it oppresses those who have taken it on. This kind of debt is characterized by high interest rates, strict deadlines, harsh amortization schedules, no tax deductibility and other unforgiving terms. Credit cards and payday loans are among the types of oppressive debt.
Working debt. Better than oppressive debt is working debt. Working debt has a cost, naturally, but it enables you to do what you want and need to do at a reasonable price. Examples of working debt include a mortgage to buy a home, student debt to pursue education or a small business loan to launch a business. This kind of debt affords you the opportunity to do something that you could not do otherwise. Working debt can be used in a strategic fashion – for instance, it’s wiser to borrow against your home at 3% and invest than to pay down your mortgage.
Enriching debt. This is debt that you could pay off tomorrow but choose not to. You have the money in the bank but are making a proactive, strategic choice to have the debt. Choosing to have debt? It’s anathema to the no-debt crowd, but this is what most companies do every day. Why? Well, if done the right way, it gives you liquidity, flexibility and leverage. Enriching debt puts you in a better position to simultaneously take less risk and increase your rate of return. With enriching debt you may also be able to produce super‐tax‐efficient income in retirement with a hybrid sell-and-borrow strategy.
A prime example of enriching debt is the securities-based line of credit. Secured by the balance in your taxable brokerage account, this type of loan lets you keep your assets invested while dictating lending terms to yourself.
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