It’s Thursday, which means it’s your weekly helping of Eddie. No, you cannot have seconds. He blogs here.
Every few months, I spend several minutes reading several PF blogs, also known as my competitors. It never ceases to amaze me at the level of groupthink prevalent in the PF community. The most common elements encountered in terms of this phenomenon are:
- Banks are out to steal your money
- Only get a no-fee credit card
- Index investing is the best and really the only way to invest in the equity and bond markets
- Maximize your RRSP and TFSA contributions or pay down your mortgage
While I could mount an effective rebuttal to every one of these assertions (ed. note: please do!), the groupthink I will refute today is the notion that all debt is bad. On the contrary, debt can be extremely good – and usually is.
The conventional wisdom is the PF community is that debt should be treated like ebola – complete eradication. The authors of several of the aforementioned blogs have stated that they “consider all debt to be bad debt” or words to that effect. This likely stems from a prior history of mismanaged finances or a date with a bankruptcy trustee. However, they are missing an important corollary that is not so obvious to the uninformed reader: debt is bad if it is used to buy non-productive and depreciating assets – also known as consumer debt. Recall my previous post and the matrix that combines whether an asset is productive or non-productive (income generating) and if it increases or decreases in value. Financing consumer spending (also known as non-productive assets with declining values) with debt is evidently foolhardy. Unfortunately, this principle is applied to every outlay or investment a person can make, not just consumer spending.
Debt is an important financial tool that can increase returns with little change to the level of risk. While a comprehensive justification is not possible in less than 600 words, individuals, especially PF bloggers, should heed some lessons from the business community. Businesses frequently utilize debt to finance capital assets (mostly income producing but depreciating). It is uncommon and even irresponsible for large businesses to use cash and current assets to completely fund capital purchases, such as a factory or piece of machinery.
Almost every single publicly traded firm’s assets are financed through a mix of equity and debt, also known as its capital structure. For example, Cenovus Energy, a Calgary-based oil company, has a capital structure of approximately 60% debt-40% equity. My employer, soon-to-be client, maintains a 50%-50% capital structure. The mix of debt and equity is dependent upon many factors, but mostly it’s because of the nature of the specific industry.
There is no reason why this principle, although maybe not in these magnitudes, can be applied to an individual or a sole-proprietorship. Adapted to a personal level, this can mean several things.
- A mortgage for a personal residence or investment property is fine and does not need to be paid off immediately. On the flip side, saving to purchase a home outright is almost never done – for many reasons.
- Investing on margin is good, providing you have a good investment strategy
- Partially financing a business or entrepreneurial venture, such as a franchise, with debt is not only acceptable, but is likely the only option
I can understand the push by the PF community to eradicate all forms of debt and to urge their readers to allocate unused cash flow to their mortgage. However, they ignore several important points pertaining to debt and its uses:
- The interest on debt is tax deductible for investment purposes (but not for the mortgage on your primary residence)
- There is an opportunity cost to everything. While paying off your mortgage isn’t necessarily bad, it does little to improve your short term cash flow and the cash can be used to invest in productive and income-producing assets. The opportunity cost of paying down your mortgage is the cash flow that could be obtained by buying an investment property, purchasing a franchise etc
- Proper use of short-term and long-term debt can improve your credit rating and your ability to borrow in the future
Debt can greatly assist in overcoming barriers to entry into some investments. For example, investing in a franchise requires a significant capital investment which almost always requires debt. Banks are more inclined to lend on a franchise because it is a proven business model. Without debt, the barriers to investing in most franchises would be near insurmountable.