I'm pleased to bring you a guest post by faithful reader and commenter, Larry Ludwig (bio below). He writes a thought provoking piece about challenging the norm of becoming debt free. You'll be smarter after reading this, guaranteed! Enjoy, and as always, feel free to debate away! Rgds, Financial Samurai
You’ve heard the financial gurus like Dave Ramsey perform pasectomies on his show and Suze Orman with her numerous “I have 50k in debt” guests. The gurus all say, debt is bad, credit is evil, and being debt free is nirvana, yada yada yada. While I do think as a whole Americans have too much consumer debt, the goal of being completely debt free is actually a terrible idea. Let me be specific: buying things that depreciate with debt is bad, that big screen TV, new clothing or car. Most of the financial gurus do not make this distinction and make all debt to be “evil”.
I believe Rich Dad/Poor Dad Robert Kiyosaki has said it best, “There is good and bad debt and being debt free is more risky than having good debt.”. Now before you go off on my recommendation of Robert and his questionable background, I believe his statement is sound and correct.
The primary reasons are:
• Opportunity Cost
• Asset Allocation
• Inflation
• Tax Deductions
• Arbitrage
• Leverage
Why Being Debt Free Is Not A Good Idea
OPPORTUNITY COST
In my case my wife and I just refinanced our house with a 30-year fixed rate at 4.875%. A great rate and will be probably not see rates lower in our lifetime. While we could pay off or accelerate the payments it does not make sense to do so. Why? Our actual mortgage rate after taxes is 3.26%, a very easy rate to beat with investments (especially pre tax) and in addition the average rate of inflation is also 3.26%.
With both taxes and inflation are expected to be higher in the future and it’s possible the actual mortgage rate will be even lower. It’s better to take the freed money that would have been tied into the house, and invest in other assets. In today’s environment you still can beat the above-mentioned rate.
Another way to look at, with inflation we will primarily paying only principal in real dollars with very little in interest payments. Your primary residence should not be looked at as an investment and if the numbers make sense take mortgage pre-payment dollars into other assets.
ASSET ALLOCATION
Let’s assume you take the financial guru’s advice and either pay off your home mortgage or accelerate payments. You will then have the proverbial “too many eggs in one basket” being your house. Most families that take this advice then cannot afford to build up an emergency savings or put money in pre-tax or after tax investments.
You’ll have too much of your dollars tied into one asset. Should pricing go down like we have seen in the past 2 years than you’ve lost real money. If you lost your job it would be much harder to get the equity out of your house to use in an emergency.
Pre-payment of your home mortgage should always occur last after any pre-tax deductions (IRA, 401k), or emergency savings. Even then, depending upon your real mortgage rate, it may not make sense to ever pre-pay.
INFLATION
Inflation has been called the “silent tax” and lurks at night eating away at your money. With our fiat currency and monetary policies, inflation is something our government wants to ensure always happens and at all cost. Being debt free robs you of borrowing money.
You not only want a ROI (return on investment) but a return OF your investment in real dollars. An example of this is a bank CD generating 4% a year interest, yet inflation is at 5%! While it’s great you have a safe investment, you are loosing %1 of your real money buying power.
Now you say what does savings have to do with borrowing? Everything. In general our government’s monetary policy is punishing savers, while helping debtors every way it can. This has become painfully obvious in the past year. You see this in every news headline and policy our previous and current administration has done.
Inflation is especially obvious with people on fix incomes (i.e. retirees). By having low fixed rate loans you are paying with future dollars that are worth less than currently.
What Will Happen With Inflation In The Future?
The $64k question is what will happen 10 – 20 years in the future? Will we have a Japan style deflation? Will stagflation of the late 70’s come back again? Will hyperinflation like Zimbabwe occur? There are a number of factors to consider:
• China and Japan will keep buying our debt? Will they just stop or slowly decrease their purchases since a devaluation of our dollar will hurt their exporting. The latter situation is more than likely
• Foreign countries that are buying our debt are now only buying short term debt. (less than 10 years). When this debt comes due, this could have massive issues for us.
• How with our government pay off the existing debt? Based upon interest alone we getting close to 40% of our yearly tax revenue.
• Will our government stop spending like drunken sailors with debt expected to pass 100% GDP in 2011? Unlike Japan, we do not have a country of savers to fall back upon.
• Will our government stop creating policies that will hurt small business?
• We are base currency for other countries, but for how long? If dollars start coming back to the U.S.A what would that do to the value of our currency?
• For the time being forget about the new health care bill, how will our government be able to fund the existing programs Social (In)Security, Medicare and Medicaid?
While there is no assurance of what the future holds, the question is do you want to ignore the risks, or hedge your bets? I choose the later with some assumption inflation will be higher than what we’ve seen for the past 30 years. Even so since 1914 the average inflation rate has been 3.26% and since 1971 (the year we completely came off the gold standard) it has averaged 4.48%, so always keep these numbers in the back of your head when debt taking on debt AND investing. By taking on low fixed rate debt, this is one simple method to hedge against inflation.
TAX DEDUCTIONS
If you are debt free, you lose your tax deductions.The Government wants you to be in debt. That’s right, why else would they have tax incentives like “Cash for Clunkers”, first time home purchase, and for businesses deductions on equipment purchases? The only logical reason is they want you to take on debt. This is related to the government’s monetary policy mentioned previously.
So if you are in the higher income brackets it makes more sense to use the tax deductions to your advantage. This is especially true on assets that generate income or increase in value over time. It’s also important to note, don’t take on debt just for the tax deduction alone.
ARBITRAGE
Arbitrage is just a fancy term making a profit from the difference in market prices. I just received a credit card offer for 0% interest for one year, with check writing expenses it was 2.99% fixed for one year, much lower than any other of the current credit card rates we have.
In the next year it’s expected all credit card transactions are going to go up dramatically. With that said if I take a one-year low interest loan and make 6% in a safe investment I’ll come out ahead with a 3% difference. This example assumes inflation and taxes paid are 0%, not completely realistic but you get the idea. While there is some risk involved (as with any investment) the risk is somewhat low and will take my chances on this type of arbitrage.
Let me also add another form of arbitrage we saw in the previous years with one of our credit cards. We had a 4.99% “fixed” rate credit card that also offered great card rewards. I recently calculated any interest we paid, minus all of the gift cards we received.
It turns out the credit card company paid us over $600.00 in the 3 years we used it and this is after any interest payments incurred! So our interest real rate on this credit card was negative. Not a bad deal if you ask me.
LEVERAGE
If you are debt free, then you won't be able to leverage cheap money to make even more money. Leverage is one of the reasons why real estate is such an attractive asset class.
I’ve seen articles that state rental housing is a poor investment compared to stocks or bonds. They use the typical statement of housing matches inflation or slightly less. While this is true, it does not take into account the use of leverage.
Lets use an example of putting down 20% on a $100,000.00 rental house. We’ll assume over time the house increases in line with inflation, and use 3% a year. So in the first year it increased from $100k to $103k, assuming the property is cash flow positive, the property increased in value 3k without doing anything. With your $20k investment, just increased to $23k or a 13% increase. So with leverage you made more money with the assistance of inflation.
Using leverage while does increases risk, it can be used to your advantage. Too much leverage (like many of the failed banks) can destroy you. So the question becomes how much leverage do you take on?
For housing the typical 20% down payment makes sense and should be the bare minimum. For other assets it really depends upon your risk tolerance, asset allocation and long-term goals.
The housing market will likely stay hot for a long time thanks to cheap money and leverage. And if you the U.S. housing market ever gets as hot as the Canadian housing market, watch out! Expect to see another 30%+ increase in prices.
Debt Free Is Not Optimal
I’m not saying go out to Macy’s and Best Buy max out your credit cards on deprecating assets. I am saying use debt to your advantage. Leverage assets that in the long run increase in value and/or generate passive income, while using cash to purchase deprecating assets.
Don’t assume that all debt is “evil”. When using debt and risk management properly, it is one of secrets of becoming wealthy. If used improperly can enslave you for the rest of your life.
Related: FS DAIR: A Framework To Pay Down Debt And Invest
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