You hear it all the time, here and many other places: Debt is bad — evil, even — you know, like smoking and drinking and gambling. Yet, despite overwhelming evidence that smoking is bad for us, almost one person out of every five still smokes. And in the past year, that number has not declined significantly.
The government even has campaigns to get people to stop doing what's bad for them. Beer companies have to add “Please drink responsibly” to their ads and, in many states, gambling is flat out illegal.
People aren't borrowing enough?
So, if debt was bad for you like those other vices, you would expect your government to have some educational program to warn you of its evils, right?
Have you ever seen that public service announcement on television from the '80s about drugs? First they showed you your brain, and then they showed you your brain on drugs? (Google “this is your brain on drugs” if you never saw it.) Now, have you ever seen a similar public service ad showing “This is your budget, and this is your budget on debt?” Nope, and you probably never will.
On the contrary, during the great financial crisis of 2008, the Federal Reserve Board and the government kept justifying all those bailouts by saying people aren't borrowing enough. From that, one would surmise that debt has to have some redeeming qualities.
I mean, will you ever hear the government saying people aren't smoking, drinking or gambling enough? Look at the government itself: Ever since the Great Depression, it has been in debt and, recently, that amount of debt has climbed to alarming levels.
Debt's stunning rise from student loans
As for personal debt, a recent breakdown showed the scope of debt in America today. Total indebtedness by Americans stood at almost $12 trillion, up from only about $7 trillion in 2003, when the New York Fed started tracking this information.
The major type of debt, not surprisingly, is mortgage debt. The second-largest category of debt, though, is a surprise to many (and a concern): student debt.
The red line shows how student debt has risen in the past 10 years from the smallest category of debt to the largest non-mortgage class.
Corporate finance models and debt — the roots of fallacy
Then look at businesses. When you go to business school, one of the most pervasive things they teach you is the importance of using debt. When the du Pont family took over General Motors back in 1920, they instituted what has become one of the basic models of corporate finance, the so-called DuPont formula which essentially says, if you're not using debt, you're not managing your company properly.
If you are inclined to think that's an old-fashioned notion, consider Apple today. No corporation has ever had as much unused spare cash sitting idly in bank accounts like Apple has in 2015 (over $10 billion at the end of 2014). Yet this month, they announced they are going to sell bonds (i.e., take on debt) of $8 billion — and this is a well-run company by most people's reckoning.
What is so attractive about debt?
Actually, the debt attraction is different for different groups and people.
For governments, it started out as a means to finance infrastructure. In 1930, $35 million in bonds (debt) were sold to finance the building of the Golden Gate Bridge. Through tolls, the loan was paid off in 1971, and no tax money was ever used. World War II was partly financed with war bonds. Without that kind of debt, many schools, dams, bridges and other parts of our well-run society could not have been funded.
For businesses, the main attraction is increasing the efficiency of capital employed. If you are a manufacturer, you can build two factories instead of one — and provide jobs for twice as many people — when you add debt to the capital you already have.
For individuals, the primary attraction is timing. You get to enjoy the benefit of that thing you finance (home, education, car, vacation) before you pay for it.
In other words, debt has its benefits — or else nobody would use it and you'd see public service ads discouraging its use.
“Okay,” you might say, “so if debt is such a wonderful thing, shouldn't we be borrowing more?” Good question, and one with several answers.
The pitfall for individuals? Assessing risk incorrectly
There is no getting around the fact that, despite its benefits, debt has serious consequences — for governments, businesses as well as individuals. However, individuals seldom recognize that the realities of debt are different for them than they are for governments and corporations. After all, governments can raise taxes and corporations can decide to sell bonds or issue stock.
Aside from the fact that individuals aren't advised by an experienced board of directors, the key problem with debt for individuals is that they don't recognize how uncertain the future can be. Things may work out swimmingly for you and you may be able to repay everything on schedule — but then again, they may not.
So the higher your debt level, the higher your risk that a bump in the road — like an employer eliminating your job (or just you) for an unforeseen reason — will drastically impair your ability to make those payments. Recovering from that scenario (or one that involves illness) is often very difficult for individuals and can set them up for even more consequences.
The consequences of debt for individuals
1. Foreclosure and/or bankruptcy. The main problem with debt is that you have to pay it back (and then some). When something happens and you can't pay it back, those creditors make life miserable for you, as anyone who has gone through foreclosure or bankruptcy can attest. And in most cases, student loan debt cannot be discharged through bankruptcy.
2. More stress. Servicing debt boils down to the mantra of “making payments.” Life, though, has a nasty habit of throwing us financial curve balls, like a close family member falling ill, the car malfunctioning or the furnace going out. When events like that occur, the stress level in a household has nowhere to go but up … and the higher the debt level, the higher the stress.
3. Decreased family harmony. They say money doesn't buy happiness; but it is also true that there just is a higher level of happiness in a household where the finances are in order and the savings account is full. And the more debt you have, the less margin you have for those unforeseen events, including handling of kids' special requests and attendance of social events.
4. Undermining long-term finances. If you have debt, you pay out money for interest; but without debt, you get to save that money — and a lifetime of such savings adds up when it comes time to retire.
There is a bigger, but more subtle, thing at work too. Often, when you decide to save up to buy something, the urge to buy that thing fades. Saving up to buy something, as opposed to buying it with debt, is a great sifter of the “really wants” from the “spur-of-the-moment wants.” (Those of us who are retired have a long list of things we wish we had never bought. If you follow a policy of having no debt, chances are you will end up with a far healthier retirement balance than if you went into debt for purchases.)
5. Freedom lost. When you are loaded with debt, you lose the freedom to pursue many things. Perhaps a dream job comes along. It is exactly what you want to do, but it pays less than you earn currently. If you didn't have debt, you would have the freedom to make the jump. With debt, those payments steal your freedom.
This applies to many opportunities from vacations to investments, even once-in-a-lifetime business opportunities. A good friend of mine in California passed away recently. Because we have no debt, we have the freedom to make an extended road trip out of it to see many friends we haven't seen for a while. If we were stuck with the obligation to make payments, we would not have been able to do so.
How my position on debt changed
Looking back over my life, I fell for the business school line that debt is good. If I knew then what I know now, I would have been more like Warren Buffett and avoided debt at any opportunity (even though he, too, has been taking on bond debt on the quiet).
As the saying goes, “Those who understand interest earn it; those who don't, pay it.” Can the so-called “responsible use of debt” help you get ahead? Possibly, it can. But it is much more likely that it will help you get farther behind.
The reason is, as Circuit City found out, life tomorrow isn't as smooth or predictable as it is today. For that reason, and for the benefit of freedom, I personally believe that debt may be good for other people, but I avoid it like the plague.
Do you have a mortgage, student loan, auto loan, home equity loan, credit card debt, or other debt? Is there such a thing as responsible use of debt for individuals? Has your position on debt changed?
Author: William Cowie
William Cowie spent 30 years in senior management (CFO/CEO) before retiring. He has a bachelor's, a master's, and a partial doctorate in management and strategy. Author of the book “The Four Seasons of the Economy,” William also assists medium-sized businesses in the use of the Four Season Strategy to help them capitalize on economic cycles. He runs two blogs: Bite the Bullet Investing (investing) and Drop Dead Money (the economy) and writes for several other blogs in addition.