Last Updated on December 2, 2024
Overview
Borrowed money is, in my mind, the most addictive drug in the world.
So many people dig themselves into deep financial holes because they finance their extravagant lifestyles with debt. Do you really need to buy another TV, finance another vehicle, or go on a vacation you don’t really need if you’re just going to take on additional debt?
There are many opinions surrounding the use of debt, especially the “good vs. bad debt” debate. I brought this up before, but I believe that there is no such thing as good debt.
“Good” Debt?
There exists the notion that not all debt is something to be shunned. In fact, debt can apparently sometimes be viewed as a beneficial thing to have.
Many people who support the notion of good debt cite student loans, business loans, and mortgages as acceptable instances to borrow money because they lead to a future job, a future business, and future home, respectively.
So many people bring up these examples because the outcomes are desirable for most people. Who wouldn’t want a stable job or their own business? However, these examples are, in my opinion, inherently flawed because they assume that the desired outcome will always happen, therefore justifying the debt that is being taken on.
Not everyone who takes on a student loan may graduate, not all people who take on business loans will be fit to run a business, and who’s to say that an individual taking on a mortgage worth hundreds of thousands of dollars may one day fall on hard financial times? Time and time again I’ve seen the proponents of good debt ignore the possibility of failure, focusing exclusively on a successful outcome.
In my opinion, taking on debt to pursue higher education or start a business is only justified if the debt can be repaid with a job secured after graduating, or from the profits of running your business. If taking on debt leads to no job after graduation or a business that eventually shuts down, then there is no way that taking on the debt can be justified.
The envisioned outcome may be favourable, but until the money has been repaid the debt will continue to be a thorn in your side. It’s not unheard of for people to be burdened by student loans, even after securing a job. The borrower will never have power over the lender: the borrower will always be a slave to the lender.
Use Debt Judiciously
While borrowing money has no shortage of downsides, it does play a role in the larger economy.
American billionaire and hedge fund manager Ray Dalio explains the role of money and credit (i.e. borrowed money) in a video he put together.
Debt allows people to obtain goods they otherwise could not obtain by paying the full amount up front. Many people use debt for big purchases, such as for appliances, hotel reservations, or vehicle repairs, while remaining in a relatively satisfactory financial standing.
Most people will have to turn to debt from time to time to finance specific purchases, but as long as that person has ascertained they have the assets to cover the debt before the debt comes due, then there shouldn’t be any issues.
Problems arise when people live far beyond their means by relying exclusively on debt to finance their lifestyles, or when debt is taken on to pursue a certain endeavour but the endeavour does not provide adequate cash flow to repay the debt.
So many people try to “keep up with the Joneses”, that is, they try to emulate the extravagant life they believe other people are living. Time and time again I’ve found out that people who “looked” well off were actually drowning in credit card debt and had poor credit scores.
Borrowing money is a necessary evil in today’s world. The next time you find yourself taking out your credit card to buy something ask yourself if you absolutely need whatever it is you’re about to buy, and if you have the means to pay off your debt in full, and on time.
Debt has a part to play in today’s world, but it is something I try to avoid using as much as possible.
Debt and Investing
In my discussion of good debt, I brought up some popular examples that people cite when they argue about the existence of good debt.
Another example I see used from time to time is the use of debt for the purposes of investing.
When using debt in an investing context, the technical term is “leverage”. That is, debt is being used to strengthen, or leverage, an investor’s purchasing power by supplementing it with extra (albeit borrowed) funds.
Some investors have successfully used leverage to achieve returns not possible if they only put up their own equity (i.e. not using any debt).
On Instagram, Reddit, and some other social media sites I’ve seen people repeatedly mention that debt should only ever be used for investing. There is some merit to that argument.
If an investor wants to purchase $20,000 worth of stock, they can put up $5000 up front and finance the other $15,000 with a loan. If the stock increases in value to $40,000 and is sold, after the $15,000 loan has been repaid the investor gets to keep $25,000. That’s a 500% return on their $5000 outlay, not bad. Assuming the $20,000 worth of stock was purchased with cash, the return would only be 200% ($40,000 /$20,000).
While leverage can magnify returns, the opposite is also true: losses pack a harder punch. This is the double-edged feature of leverage some people conveniently choose to ignore.
The collapse of Long-Term Capital Management is a classic example of what happens when too much leverage is being used, and if the corresponding risk is not adequately managed.
Wrapping Up
Debt, if used recklessly, can easily land anyone in a very bad financial situation, very quickly. Though some people argue that good debt exists, there may not be ends to justify the means. Even if taking on debt results in a desirable outcome, until that debt is repaid it will continue to be a liability.
Investors can use debt (or leverage, for the sake of being technically correct) to amplify investment returns. However, extreme caution must be exercised when using leverage. Long-Term Capital Management was run by some of the smartest people in finance, but it still went under because of too much leverage. If a hedge fund led by two Nobel Laureates collapses due to leverage, then any investor can fall victim to the same fate.
It would be advisable for young and new investors alike to refrain from using leverage for investing. If you do not have enough money to invest right now, continue saving up until you do. The hassle and headaches that come with using leverage may not be worth the slightly better return you might achieve.
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