David R. Henderson  

In Praise of Debt

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But borrowing doesn't have to dull husbandry. Indeed, it can sharpen it. Taking on substantial short-run debt can be a great way to save for your retirement. Really? Going into debt to save? Isn't that a contradiction? Bear with me.
This is from David R. Henderson, "In Praise of Debt," one of the two Econlib Featured Articles for June. Read the whole thing.

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COMMENTS (15 to date)
Doug T writes:

One word: "oft" (previous line, Ham. I.iii)

You may hate debt, and have the sporadic freelance income to pay it down. But most people with regular jobs and regular paychecks do not. Tapping into a personal line of credit is "oft" the first step down a slippery slope.

And your modest personal investment leverage has worked (so far) because asset prices have been rising. But should we go into a sustained era of mediocre returns (i.e. 1965-1978) your modest leverage will be an annual drag on personal wealth--$28,000 over 10 years, after taxes--with little if anything to show for it on the other side of the ledger.

David R. Henderson writes:

@Doug T,
But most people with regular jobs and regular paychecks do not.
That’s fine. I discussed how I did it. There are other ways. With just a regular pay check, take x amount out of each check and pay down the debt.
Tapping into a personal line of credit is "oft" the first step down a slippery slope.
It often is and it’s often not. If you lack self control, you can get in trouble, as I noted in the article.
And your modest personal investment leverage has worked (so far) because asset prices have been rising. But should we go into a sustained era of mediocre returns (i.e. 1965-1978) your modest leverage will be an annual drag on personal wealth--$28,000 over 10 years, after taxes--with little if anything to show for it on the other side of the ledger.
In your calculations, did you take account of reinvestment of dividends? I’m guessing you didn’t.

zeke5123 writes:

This is an interesting topic that sometime ago I would've been in complete agreement with. But I read some of Taleb's work, and am concerned that debt leads to fragility. Because we aren't great at predicting the future, we risk any downturn being a catastrophic event.

Leverage may also prevent us from pursuing otherwise lucrative options. Imagine you have student loans and are working a job that pays 100K. You need all of that 100K to make your 25K student loan payments + other life expenses. Could you afford to take a chance on a start-up that offers you equity + 50k? Probably not.

This is not to say that I am adamantly against leverage. As someone who has used leverage for my professional degree, that would be hypocritical. But I do think we should be very hesitant to use leverage and seek to be antifragile.

michael pettengill writes:

So, sacrificing consumption to fund savings has no reward, but sacrificing 4% more to pay off an equal sum in debt is highly rewarding?

David R. Henderson writes:

@zeke5123,
Imagine you have student loans and are working a job that pays 100K. You need all of that 100K to make your 25K student loan payments + other life expenses. Could you afford to take a chance on a start-up that offers you equity + 50k? Probably not.
That person who’s paying $25K in student loan payments must have borrowed over $200K. I wouldn’t recommend that.
It is true that you can come up with scary debt numbers. That doesn’t much address what I was discussing.

ZC writes:

Great post. Debt is just a tool -- use it correctly and it's a great way to accomplish certain objectives. Far too many people treat it like an evil four-letter word (I blame the Dave Ramsey cult), rather than something to be employed to your advantage when such opportunities arise.

"That means that I would miss out on one year of tax-advantaged saving," yet you wait until April of the subsequent year to fund tax advantaged accounts (you contributed your 2015 IRA allotment in 2016)? If a little debt is good, may as well rack up a little more one year and 'catch up'. Load that account up January 1 and don't miss out on year [plus] of tax-advantaged saving.


john hare writes:

Far too many people treat it like an evil four-letter word (I blame the Dave Ramsey cult), rather than something to be employed to your advantage when such opportunities arise.

Dave Ramsey has some excellent advice for people without self control. Just as the car example in Davids' linked article. A very high percentage of people lack that self control and really need to follow that debt free program. The problem is that Dave Ramsey is a one size fits all kind of guy. Most major projects would never happen under his guidance.

For one that uses debt as a tool though, it is very enabling. I typically buy and finance large equipment just in time for a major project. The down payment and other up front expenses are often paid for by the piece of equipment before the first monthly payment comes due. After that, a monthly payment is normally equal to about two days of rental, so we turn a profit even during payments as long as we use it three times a month.

Sometimes I would like for Dave Ramsey to try shovel digging footers for days on end when an excavator can do the same job in hours.

David R. Henderson writes:

@ZC,
If a little debt is good, may as well rack up a little more one year and 'catch up'. Load that account up January 1 and don't miss out on year [plus] of tax-advantaged saving.
Good point. The problem is that I don’t know that early in the year how much of a SEP-IRA I will qualify for and how much of a Roth. In 2015, because my wife had an unusually good free-lance year and I had an unusually low-expense year, we each qualified for only $1250 of Roth.

David R. Henderson writes:

@john hare,
Great story.

ZC writes:

@DRH
Easy solution. Max out the Roth's, or take your best guess at what you'll be able to put into for the Roth for the year, if it turns out you over-contributed, you can pull the excess contribution out with no penalty as long as it's done before the tax filing deadline for the contribution year (no penalty for the excess contribution, you'll have to pay tax and early distribution on any earnings).

David R. Henderson writes:

@ZC,
Thanks.

Frommer Bischkva writes:

The example of mortgages, the most prevalent and in dollar terms the most significant form of debt Americans assume, doesn't fly.

Home buyers frequently gauge mortgage debt against what they would otherwise pay in rent. Individuals whose mortgage + interest equals, say, $1500 per month could hardly expect (all things being equal) to pay much less than that in rent.

You can't say the same for almost any other type of debt, especially consumer debt.

Yes you CAN drive your 6 year old car for another four years. No you DON'T need that $8000 vacation when a $2000 trip will provide the same R&R. And yes, your child will live long and prosper if she attends a $20,000 per year state school instead of a $70,000 private college. But housing costs are by and large unavoidable.

At the expense of sounding like a cranky moralist, I must protest that most consumer debt adds nothing to a person's happiness and well-being. It feeds the worst personal habits and supports the predatory bottom-feeders of our economy. To state otherwise, irrespective of one's level of "self-control," is irresponsible.

Jonathan R Lorenz writes:

"It often makes sense to be a debtor. If you use debt wisely, you can have a nice house and get rich."

You're promoting an old and false American dream. Promoting Americans to be a slave to the banking system is not good.

john hare writes:

Jonathan R Lorenz writes:
"It often makes sense to be a debtor. If you use debt wisely, you can have a nice house and get rich."

You're promoting an old and false American dream. Promoting Americans to be a slave to the banking system is not good.

The critical word is wisely. I would like to add you to the list of people that should try getting work done without the right tools when investment is available through debt. Hint, payroll and overhead on four shovel laborers is massively higher than that on one operator and the equipment payment. Understanding that allows me to pay higher than average local wages, and higher than average crew moral in the process.

20 or so years back I lost an argument with a friend of mine that owns a redimix concrete company. He said that replacing a $10.00 an hour laborer with equipment would make the payments on $100,000.00 of equipment, and I called BS. He said run the numbers. $10.00 an hour for 160 hours a month is $1,600.00 a month plus 7.65% SS and Medicaid,plus unemployment, workman's comp and office time for it brings it to well over $2,000.00 a month. $2,000.00+ a month buys $100.000.00 worth of equipment over 4-5 years.

This doesn't even include the time and cost of dealing with low skill workers which is much higher than most people realize.

Doug T writes:

My apologies - I needed to change my defaults. Total return from 1965 to 1978 with dividends reinvested was 3.7% annualized. Data on interest rates from that period is hard to find, but the average bank prime rate from that period was 7.2%. Your personal leverage would still suffer from "negative carry."

Returns for the past 35 years have been turbocharged by interest rates falling from double-digits to almost zero. With 10-yr US Treasuries currently yielding less than 2%, that degree of disinflation is no longer possible.

Borrowing short and investing long (equities are long-duration securities with a residual claim on cash flow) works great when rates are falling. Not so well when they are rising.

I think you are suffering from recency bias.

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