Debt – beyond good and evil
Most people think debt is bad. But this is not necessarily true. While it is true that debt is often abused and misunderstood, debt can be a positive. By understanding the benefits and drawbacks of debt, you can use it to your advantage and, more importantly, avoid the pitfalls of debt.
The real question is not whether or not debt is bad but rather what debt is good and bad. To decide whether it is a good idea to borrow, there are three things to consider: (1) the interest rate, (2) whether the debt is tax-deductible, and (3) whether you will have the cash flow to pay back the loan as it comes due.
If the cost of the debt is lower than your cost of capital, it makes sense to borrow. Even though this is the right measure to use, most people borrow on a need basis. If they need cash, they will borrow; if not, they will remain debt free. But, just like any corporation, the right capital structure usually involves having some debt. By using debt in a positive way you can reduce your cost of capital and increase returns.
Just like most economic theories, minimizing your cost of capital sounds easy but putting the theory into practice is ridiculously hard. First, what is your cost of capital? Second, even if the interest rate on the debt is below your cost of capital, would your cost of capital be reduced by taking on the debt? (It may not be reduced because more debt sometimes means more risk which would increase your cost of equity and cost of capital.)
Luckily, we don’t need to know our exact cost of capital. We know that our cost of capital must be at least as large as what we can earn in a money market or short-term CD after tax. (I assume money markets and CDs are risk free.) If we are able to borrow at less than what we could earn in a money market after tax, we have an arbitrage situation. (That is, borrow as much as you can at the low rate and earn a higher rate in the money market. Also, there would be no extra risk because you could pay off the debt at any time with the money market.)
For example, I currently use credit cards to finance a portion of our portfolio. The cards carry an average interest rate of 2.04%. This is easily less than my after tax cost of capital. Additionally, I can easily make more than that investing in equities. As long as we are able to manage our cash flows, we should end up ahead. (For a less risky version of this same type of transaction, see savvysaver.blogspot.com. The author used 0% credit cards to finance investments in a money market.)
The same type of analysis should be applied to any decision to take on debt. Of course, the analysis can be more complicated. Or the analysis can be frustrated by the “need” to have something. But, if you are disciplined enough to stay away from high cost debt and are able to use low cost debt to leverage your investments, you will be able to increase your returns for very little risk.
Nathan Whitehead said,
February 5, 2006 @ 2:59 am
I thought about it and concluded that it’s not a good idea to use 0% offer money to invest. (blog entry).
Am I wrong? My main argument is that you’ll lower your credit score, which lowers your available money in financial emergencies.
Brian said,
February 5, 2006 @ 11:20 am
You have a good point that I didn’t address. You will lower your credit score if you use this strategy. However, your credit score will not be effected that much if you only use this strategy with a portion of your total available credit. (One yardstick the rating agencies use is how much of your potential line of credit you have outstanding.)
For example, I used this strategy before I purchased a home with my girlfriend (now wife) and she did not. When we checked our credit scores before the transaction her credit score was 720 and mine was 715. With this score I am still bombarded with credit offers and would have no trouble using available credit should the need arise.
Thanks for your comments addressing a potential problem with the strategy.