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April 20, 2011

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I guess I fall more into the "bubble economy" rules. I have a car loan (<6%) and some student loans (~2%). The student loans are so low interest that paying them off would cost me much more in opportunity cost than just paying them at the minimum rate. The car loan now only has 6 months remaining and the total remaining interest to be paid will be around $35. Again, no reason to pay it off. We never have carried or will carry a balance on a credit card.

My wife and I recently bought an investment property with an 80% mortgage at 5%. Again, we have no desire to pay this off any more quickly than the minimum amount. We instead put all of our savings toward the purchase of another (currently in escrow) and will continue to do this as long as the market conditions allow. Our first house is currently returning us around 16% on our investment, with hundreds of dollars a month in positive cash flow, and the second one will do the same. I have absolutely no reason to want to pay down the cheap fixed-rate debt anytime soon.

Debt is Debt

No matter how you qualify ( good, bad, toxic) or try to make it sound positive or necessary it is still debt.

Too much will make you a slave to the payment, some is necessary in cases of just starting out with a career or house. However the US got into trouble when people took out too much debt that could not be repayed.

Now we all are paying the price with devalued housing, little job growth and alike.

I mostly agree with you!

I wouldn't mind borrowing to purchase some investments like real estate, but so far I haven't so because I don't think I want to deal with the headaches that such an investment would entail.

I guess if I had a rock solid idea, I might borrow money to pursue that idea, but most of the time I can poke holes in my ideas...

I follow the "new" rules, I see no reason to pay off subsidized student loans (SL) when they are earning no interest and the money is sitting in my bank account earning me interest. My 4.75% mortgage is a keep, especially since I know I will be moving in 3-5 years and may want another down payment (we will be keeping the current duplex as a rental). I will however, pay off the SL as soon as I graduate because I will need less in my investments once I don't have that bill.

Not so long ago, "experts" created the bubble economy rules as the new rules to thrive in the bubble years. These same experts debunked those new rules after the bubble popped and now have a new set of new rules which are likely to be debunked and replaced by a newest set of new rules at some time in the not-so-distant future.

It's just a matter of time before these same experts discover that student loans ruin lives as easily and quickly as credit card debt. Don't the experts know that student loans are forever, regardless of your ability to repay? Folks without debt of any kind are considerably less likely to declare bankruptcy than debtors. The original rules continue to hold true regardless of economic conditions.

My take on debt is very simple and as follows:

If I can get a higher rate of return by investing my money than I am paying in interest then why not take out a loan for something I really want.

That's why in the past I have had car loans through my Credit Union and mortgage loans on property we have purchased.

Looking back I suppose during the height of the DOT.COM Bubble when I was making 20% and higher returns on my investments I should have been very greedy and gone on 50% margin to make even more money. The only problem with that is that I knew the Bubble would eventually pop and the market would take a huge hit but I didn't know when, meanwhile the daily fluctuations would have been that much greater which is very stressful. I also am not good at handling stress so I try my best to avoid it.

These days it's not an issue since my investments are set up to return a little over 5% and margin loans are considerably higher than that so it wouldn't make sense to borrow money.

I know many people will say that debt is bad in any form. In a way they are right, but I wanted to own a house before having children, not until I saved up 99% of the price. And there are writeoffs to consider that make mortgage debt not quite as disasterous as the rest.

Most people in this school of thought tend to people who are heavily vested in savings accounts and even CDs etc. Im more about dividend stocks and mutual fund investments so that I outpace inflation.

FMF,

You said:

"My take is that we all should be debt free for most of your life, with a limited time in debt for an education and a house. The small business loan suggestion -- I would say take one only if you had a great reason to believe it would be worth it (like orders in hand that you need the loan to fulfill.)"

-------------------

I have seen simulations, have participated in business planning exercises, and have examined how many businesses operate. One thing I have seen in common among them, most of the time, the most successful companies took on the most debt (I realize this is a one sided view and does not show the reverse side which very well may also show that the businesses that went broke were also more likely to take on more debt, but many factors lead to failure so I don't know if it is true).

I am curious as an MBA and a business executive, what your take is on business debt. Most businesses have debt to run their business, many of them are never fully out of debt if they are growing. Often times the more successful your business the more need for debt. And success doesn't necessarily mean orders in hand. It can mean the business is going well and you see untapped markets and move to expand to be able to service those markets. The risks are you could have done poor analysis and the market isn't really as lucrative as you thought, the economics could change and pull the rug out from you before you get your expansion completed (think telecom expansion in the late 90s), some other competitor could beat you to it and now you are late and in a price war. All of these could go wrong yet any business that wants to grow takes those risks and borrows money to do it. Some of them borrow the money and go broke because of the risks I listed or others I didn't.

So do you think it is wise for business to also avoid debt at almost all costs unless orders are in hand so to speak?

If you think the same rules apply to businesses as to individuals who are trying to start or grow a business then the next questions are moot. But if you think different rules apply, why is that? Is it because you think that businesses are more likely to understand their risks and have a better handle on potential for success than individuals? Is it because you think its a different thing to risk business solvency which is likely not your personal assets than it is to risk personal solvency over an expansion or growth plan? Something else?

I am not arguing for a position, just trying to understand how you view the differences between business debt as a business person and personal debt for personal businesses.

Thanks.

Dan Miller, author of 48 Days to the Work You Love, has a simple rule that I tend to agree with. You shouldn't take out any more in student loans than you plan to make in the first year of your profession.

Apex --

I think there's a difference between (reasonable) business debt and personal debt in general. Every business I've ever worked for has had debt of one sort or another and most have done well. Of course I was not personally responsible for that debt (nor were any of my co-workers.)

Concerning individuals who are trying to start or grow a business, that's where it gets a bit gray. Just like with borrowing a reasonable amount to fund a college education or a home, I can see that business debt by an individual can be advantageous for a short period of time and for a limited amount.

Personally, I would never take on a massive amount of business debt or debt that was risky as an individual. Part of the reason is that it's just not my personality to do so and part is that I think there are better/different/more likely ways to become wealthy without doing so. Yes, I know that many people become wealthy as the result of owning businesses and they often take on debt to do so. I also know that many businesses fail and leave people financially devastated.

I think, too, that there is a fairly significant difference between mortgage debt and most other kinds of debt.

Credit card debt usually is not collateralized, and the "assets" purchased with CCs cannot be sold to recoup the costs. Auto loans are collateralized by a vehicle which is often worth less than the debt owed. Student loan debt is not tied to any tangible asset, nor are personal loans. Business loans are often collateralized to the assets or name of a business, but those may or may not be enough to cover the loan value.

On the other hand, real estate debt is tied to a property that is often worth the amount paid for it. In most cases (the recent real estate trends notwithstanding), property values maintain or increase over time. There are few situations where a piece of property will literally become worthless. In many cases, real estate can actually pay for its own debt with income from tenants. This, to me, makes it the best kind of debt to have (and I'm not even considering the various tax benefits involved in real estate investment and real estate debt).

FMF,

Thanks for the response. I don't disagree. Leverage (debt) is a magnifier. Problem is almost everyone who starts a business is an optimist and sees the upside and probably an optimistically distorted upside. They often think the downside can't or won't happen. However statistics show it often does. And if you used debt then the downside is magnified.

Of course I have used debt multiple times to grow personal business ventures. I don't believe I had rose colored glasses on when I did it and am currently doing it, but I suppose the first sign that you might be wearing them is thinking you are not. :)

@Jonathan,

You are signing my song.

However, there are plenty of incompetent real estate investors who can manage to go broke even in a stable to appreciating market when they can't make their mortgage payments. The purchase still has to make sense. The property has to cash flow. You still have to manage the business and have the working capital to deal with unexpected repairs and routine maintenance. And you have to keep the properties rented and with tenants that don't cost more than they are worth.

With real estate it's usually not the debt that brings people down. It's that they think it's "passive" income. I just take out a loan and the money starts coming in. Doesn't matter if I pay too much for the property, or don't have any extra cash to run the business or don't keep on top of my tenants and actively manage my properties. They are wrong and eventually they go broke. This story gets repeated over and over. The recent real estate crisis exposed the huge number of incompetent investors in the game once they could no longer ATM their investments. I am now able to purchase their mistakes cheaply but as soon as real estate bottoms and starts to recover this game will be started anew by thousands of new incompetents. There seems to be an endless supply of them.

I agree with FMF's philosophy on debt and agree with both Jonathan and Apex regarding real estate.

On another note, I would love to see a "Reader Profile" featuring Apex.

Apex, thanks for the wise words, especially as I am a beginning real estate investor. We love our tenants, but just this week had our first "showdown" with them over paying for an improvement they wanted. We still don't know how that will turn out, but we've been getting good negotiating experience!

Fortunately we have excellent (and successful) mentors, and the property DOES make sense from pretty much any angle and in just about any contingency.

I am with you CT - I find Apex's comments and questions to be very well thought out and interesting. I would like to read a profile on Apex as well...

I appreciate your perspective and agree on most points related to debt and taking on debt.

The only one that I have caution about is taking on student loan debt "based on what your post-graduate career will earn you".

I think that a post graduate job (or even guaranteeing that I'll graduate) and income commensurate with it is an assumption that may or may not become reality.

Derrik Hubbard, CFP

That's funny, I've never heard anything but what you call "the new rules".

All debt is toxic? Why would anyone borrow money? Clearly there are cases where the money they borrow can make them more than they started with.

Don't pay off debt? What if you feel the probability is low that you will clear a return greater than the interest rate you are paying? Of course it makes sense to pay that debt off.

It comes down to what you can do with the money. If you are an expert house-flipper and can make money even in bad economies, borrow as much as you can. If you are incompetent, or not competent enough to make money in a bad economy, don't borrow anything and wait until the situation changes so your lack of competence won't produce a negative return.

In the same light, if you have high-rate debt or are considering burdening yourself with high-rate debt (like credit card), only do so if you feel you can earn a higher rate of return with the money you borrow (this is often what small business owners do). Your competence and a little luck will determine whether this is a wise move.

I wouldn't say there's a such thing as "good debt".

It's better to say that there are forms of debt that carry significant upside and limited downside, and those forms of debt are worth taking on if you (1) can afford it and (2) can't get the same upside without it. But you've got to be sure about both 1 and 2.

Even I believe that we cannot categorize debts as good and bad. For whatever reason you borrow the money, you have to pay it back on time. If there is no other ways to finance, then you have to borrow. But one has to be careful when borrowing money without going overboard. Your post is interesting and it has initiated a good conversation. Thanks for this.

CT --

A profile with Apex is coming. Stay tuned...

Awesome!

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