Monday, August 03, 2015

Good Debt, Bad Debt

There are lots of great rules of thumb for financial planning. It is always more complicated than that, but precautionary rules can protect you when you don't fully understand something. One rule which will save you a lot of pain is 'Neither a borrower nor a lender be'. Debt can be a great lubricant or catalyst, but it can also be a sticky trap. It depends what you do with it, and what happens. Avoiding debt completely allows you to have more control over the outcome. Avoiding debt completely also means that outcome may be well below your potential. There is bad debt and there is good debt. Knowing the difference is important.

Even though debt is often used in businesses and personal finances, it is closer in character to cash than to a company that makes things or a person that has a job. Money isn't actually a thing. Since we can't think in abstract terms and need stories to make sense of the world, the story I like is that my money is my employee. If you hold cash, your employees are sleeping. Hold it in the bank, and bank will lend your employees out to someone else. Lend your cash to someone else, and they will pay you a salary (interest) for your employees time. The fruits of your employees labour will belong to them. Invest the money yourself and the fruits, rotten or juicy, are yours.

Salaries and interest are reasonably predictable. You can plan around them. They don't depend on weather or ups and downs. It is only as an employee climbs the ladder and becomes a manager that owners try (often badly) to link the risks they face to the manager's pay. When debt gets involved there is a disconnect between the thing the money does and the borrower-lender arrangement. How they are linked depends on the law of the land so it gets really complicated, but they aren't directly linked.

It may be useful to think of interest and rent as interchangeable. I have often heard the saying 'I'd rather be paying off my mortgage than paying off someone else's mortgage' when talking about rent. They are not the same thing however. I don't like the analogy and think it gets people into trouble. The amount you borrow to buy a house is the value of the house at the time you borrow. I haven't heard of mortgages where the capital owed depends on the house valuation. I haven't heard of rents that depend on the mortgage value. The amount borrowed becomes its own thing. Like cash, debt is nominal, meaning it isn't a real thing.

Debt is useful when the money gets put to work. If you can borrow and your money can earn more than it costs, you are adding value. It is very hard to look far into the future. The world is complicated and things go wrong. The more confidence you can build in what your money can earn, the more confidence you can build in borrowing. What it earns is its fundamentals. An estimate of the present value of what it will earn is it's price. Price is also a factor of supply and demand. Sometimes supply and demand completely dominate the long term value of the fundamentals. A glass of water when you are dying of thirst doesn't change price because rain is due in a week.

Some people are really good at making money off price changes. They use various factors to try understand the supply and demand dynamics. This is called speculation. My preference is for trying to understand the fundamentals. This is called investing. Trying to understand what the money actually does. Leverage with cheap money (lots of borrowing) can magically make thing that aren't doing a great job make lots of money. Money makes money. It magnifies everything. Including losses.

The book on the difference between Speculation and Investing

'Neither a borrower or a lender be' is a good rule of thumb. If you want to be braver, try get an understanding of what the debt will do. If it is for making something useful and can earn its keep, it may be the good kind of debt. If it is just for spending or doesn't do a good job, it can take on a life of its own and swallow you whole.

You goya be careful if you borrow

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