May 2024
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Lest Dave Ramsey show up at my doorstep and smack me upside the head with a copy of The Total Money Makeover, I need to be specific: Debt is good when it is used as an investment. If you borrow money at a 7% interest rate and then invest it in a way that earns you a 10% rate of return, that money is now working for you – rather than you working for money.
So, let’s get one thing straight. Credit card debt = bad debt. Why? Because you’re borrowing money at 20% interest to “invest” in new shoes. Not only are you paying for the shoes, but you’re essentially renting the money you used to buy them. It only takes 4 years at that kind of interest for the cost of those shoes to double. Congratulations, you are now working part-time for the credit card company.
But there are other types of debt that are constructive. For instance, if you have a business, every dollar that you invest in the business could conceivably generate an increase in the business’s profit. This is called your “return on invested capital” (ROIC). If you can increase the business’s profit by $20 for every $100 that you invest in the business, you have an ROIC of 20%. Is it then a good idea to borrow money at 10% interest? Yes. That money is working for you.
Mortgages are another good example of using debt constructively. I know, I know. I’ve developed a reputation for being a bit “anti-home-buying” in this current environment (You can read the incriminating evidence in this article: “Renting vs. Buying: The Script Has Been Flipped”). But it’s always good to examine the counterargument to every perspective. Through what perspective would it make sense to use a mortgage as constructive debt for investing in real estate?
Let’s start with ROIC. In my lifetime, the average home has increased from $112,000 to $513,100. That’s about a 4.1% increase per year, which is much lower than today’s 7+% interest rates. Not a good start.
But there’s more to real estate than price appreciation. When you take out a mortgage, you are also replacing the cost of your rent, which you should add into the equation as a phantom benefit.
If I buy a $1M house by taking an $800k mortgage with a 7% interest rate, my after-tax costs would be about $70k/yr (I won’t bore you with the arithmetic). Since homes increase in value by about 4% per year, I would expect the house to increase in value by $40,000 next year. Paying $70k/yr for a $40k/yr gain is not a great investment, which is why the housing market has frozen up during this interest rate hiking cycle.
But, we have to consider the opportunity cost/benefit. If I subtract out the $50k that I’m currently paying in rent, my additional costs are only $20k/yr. I increase my costs by $20k/yr, while increasing my assets by $40k/yr. That’s a 100% ROIC on my additional expenses. Not to mention, the first $500k of appreciation on a primary residence is tax-free for a married couple, so it’s just as good as investing in a Roth IRA,
This is not a trade-off that I am personally interested in, because I would prefer to have a positive ROIC on my total housing costs (the full $70k). But it makes sense from a certain point of view. And I would be remiss if I didn’t mention the conventional wisdom that I would be able to refinance this mortgage at a lower rate in the next few years. But predicting the direction of interest rates is not my game.
I’ll leave you with an anecdote that paints a picture of what I think is the perfect use of debt at the exact right time.
In my 20s, I was renting a 1-bedroom apartment with two other grown men. 2 of us slept in bunkbeds, and 1 on the living room floor. That’s what you had to do to live in LA for the privilege of chasing the dream of an acting career. We were posterchildren of the “Baristas with Bachelor Degrees” generation. Adventurous, exciting, and dumb.
Conversely, one of my best friends did the opposite. He did the sensible thing of leaving California for lower cost of living WAY before it was cool. While working part-time in a Costco pizza kitchen, he and his wife managed a $5000 down payment on a $150k house. Their mortgage was about $850/mo, which was LESS than what they were paying in rent. Their monthly expenses went down, and at the same time acquired a $150k appreciating asset with $500k of potential tax-free growth. Their monthly payment never increased, and they later sold the house for a huge tax-free gain. All for a $5000 investment. All while making pizzas at Costco. That is my idea of good debt.
P.S. If you're trying to decide whether to keep renting or purchase a home, this NY Times Calculator is quite comprehensive: https://www.nytimes.com/interactive/2024/upshot/buy-rent-calculator.html?smid=url-share&unlocked_article_code=1.rk0.bixT.nXapIcSjc01S
Disclosure: This information is presented for discussion and illustrative purposes only and is not intended to constitute investment or financial planning advice. The views and opinions expressed are as of the date herein and are subject to change. It should not be assumed that Morton will make investment recommendations in the future that are consistent with the views expressed herein. Morton Wealth makes no representation that the strategies described are suitable or appropriate for any person. You should consult with your financial advisor to thoroughly review all information and consider all ramifications before implementing any transactions and/or strategies concerning your finances. Any investment strategy involves the risk of loss of capital. Past performance is no guarantee of future results.
