By Shailendra Kumar Rai and Thomas J. Anderson
We usually hear that debt is bad and one should be debt-free at the time of retirement. To become debt-free is seen as the first step to financial liberty. That is not all. Conventional wisdom says that debt creates anxiety, stress and tension; causes you to waste money on interest and increases risk in your life. The advice is that being debt-free is less risky than having debt, etc.
Most of us blindly accept this conventional wisdom. But is conventional wisdom right? Where do these beliefs come from and does the evidence support these conclusions?
The decisions you make with regard to debt are among, if not the, biggest financial decisions made in your life. Debt has the possibility of creating enormous wealth. Debt has the possibility of destroying your life. However, like salt, debt must be used very carefully.
High interest debt
Let us agree that high interest debt, like credit card debt, is bad. But just because some categories of debt are bad, does that mean that all categories of debt are bad? Some investments are bad, but not all investments are bad. We must explore the middle ground and learn how to use the right debt, the right way.
Companies work both sides of their balance sheet to become wealthier. People are not companies but they can learn from their actions. The sensible use of debt provides liquidity and flexibility, allowing smart companies to jump on opportunities and ride out emergencies. Why would not smart investors who are building wealth do the same?
Debt is risky, and in a perfect world, we would all rather avoid risk. The problem is that we do not live in a perfect world. In our imperfect world, many people buy things on debt, things that they could not otherwise afford with cash in hand, including buying a house or a car, and investing on good education, or investing in their small businesses. As a result, many, if not most, people chose to take on debt early in life and spend their lives trying to pay it down. Is this a good strategy? Should people borrow money? If so, how much should they borrow? How fast should it be paid back?
Net worth
Whether debt is bad or good also depends on your resources relative to your needs. If you have a net worth greater than 30 times your desired income in retirement, chances are that you do not need debt. Chances are high that you can afford to pay cash for something. However, if you have not yet saved to this level, whether or not you can afford it is just one part of a much bigger picture. If you want to retire, you owe a debt to your future self.
Discussions around debt require challenging conventional wisdom. The big picture is quite simple: if you believe that you can earn a long-term rate of return higher than your cost of debt, debt will have an a positive impact on your life.
We, however, are not suggesting you borrow too much in good times. You must be aware that there are companies sitting on piles of cash and also having loads of debt. They do it strategically because they value the liquidity, flexibility, and tax benefits associated with debt. This concept also works well for individuals.
(Rai is faculty member, Management Development Institute, Gurgaon and Anderson is founder, former CEO, and chairman of Supernova Technology, USA.)
Views expressed are personal.