The Beauty of Debt

In this post, I’ll talk about the advantages of taking on debt.  Many of us know that debt is sometimes unavoidable and can come in many forms.  Acceptable debt might include home mortgages or student loans.  Unacceptable debt might include car financing, credit card debt or, perish the thought, payday loans.

So how do we know what types of debt are acceptable?  First, let’s start with a general understanding of how debt works and why it’s not always good or bad.  For example, let’s say that our friend Bob wants to start a business that sells ice cream.  Bob needs $200 to buy the materials.  And he isn’t sure whether he wants to invest $200 of his own money or take out a small business loan.  For our first scenario, let’s assume that Bob can get a 5% loan from his local bank and that he could make an annual profit of $100 from selling his ice cream:

Scenario 1

 Invest  Borrow Interest  Profit Return*
$50.00 $150.00 5% $100.00 -115%
$100.00 $100.00 5% $100.00 -5%
$200.00 $0.00 5% $100.00 50%

Ouch, Bob would not do so well if he borrowed money from the bank.  In fact, he can only make a positive return on his business (50%) if he invests $200 of his own money.  But now let’s assume that instead of $100, he can make a $200 profit from selling ice cream:

Scenario 2

 Invest  Borrow Interest  Profit Return
$50.00 $150.00 5% $200.00 85%
$100.00 $100.00 5% $200.00 95%
$200.00 $0.00 5% $200.00 100%

Now things are looking a bit better.  Bob still can’t make as much from borrowing as he could if he invested his own money, but at least he’s not in the red anymore if he borrows.  Okay, one last scenario – Bob can make a $300 profit from selling ice cream:

Scenario 3

 Invest  Borrow Interest  Profit Return
$50.00 $150.00 5% $300.00 285%
$100.00 $100.00 5% $300.00 195%
$200.00 $0.00 5% $300.00 150%

There it is!  Now, Bob is clearly better off borrowing than investing.  He makes a whopping 285% return by borrowing $150 (or 75%) to fund his business.  Compare that to the 150% he would make if he borrowed nothing.  As a matter of fact, the more he borrows, the better return he’ll get.

So you can see from Bob’s example that the more profit you expect on an investment, the better off you are borrowing.  And most of us already know that a higher interest rate will lower our return.  Now, we can look at our own personal debt in the context of interest rates and expected profit.

Take student loans for instance.  Student loans are generally recommended because we expect education to lead to better job opportunities or, in the very least, fulfilling careers.  Likewise, mortgages help us buy houses so that we no longer need to pay rent.  As further icing on the cake, the houses we buy may appreciate in value.  So the more we expect to profit from investing in houses or education, the more sense it makes to take on some low interest debt.

On the other hand, car financing and credit card debt generally do not lead to profitable investments.  For example, would it really be worth it to finance a brand new $30,000 car over spending just $10,000 in cash for a reliable used one?  Probably not.  And in the context of credit card debt or payday loans that carry steep interest rates, our expected return on investment decreases even more dramatically.

So to sum it all up, low interest debt can be a great tool to have when you’re investing in profitable ventures.  But if you’re not, debt can be dangerous and crippling to your personal finances, especially if it carries a high interest rate.

*Here’s how these returns were calculated: (Profit – 1.05 x Debt)/Investment = Return




May 2016 Net Worth Update
Individual Stocks vs. Index Funds

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