While personal finance can be summed up in less than 10 words, we can lay out the principle for borrowing in just four.
Obviously those four words aren’t enough to fully explain the concept. It’s just an alliterative way to help you remember the rule.
Here’s what the rule means: Only borrow when the expected payoff from borrowing exceeds the cost of borrowing.
Let’s look at a few examples to illustrate this concept.
Three Times It (Might) Be Okay To Borrow
Investing in your education is like investing in your future earnings.
My wife went to school for nursing and racked up five figures in debt. Because nursing is such a valuable skill, she landed a good job straight out of school and paid off her debt in a little over a year.
When it goes well, funding your education has the potential for an amazing return on investment.
Property is valuable.
It’s hard to imagine a situation where property would no longer be valuable. Whether it’s buying your own home or an investment property, borrowing can be a great way to come up with the money. After all, not many of us have six figures of cash just sitting around.
Both owning and renting can be good options, but one advantage that owning has is that a portion of your payment goes to the principal of the loan. Once your loan is paid off, you own a valuable property. It’s like converting part of your biggest expense into a forced savings plan.
Buying a rental property is even more of a cheat code. Just like owning a primary residence, a portion of the monthly payment is going towards your ownership of the property. The big difference with a rental is that you aren’t the one making the payment.
Starting/Growing a Business
Unfortunately, this is the one you probably think doesn’t apply to you.
Not everyone should start a business, but too many that should don’t because of fear.
It’s also worth pointing out that you don’t strictly need a loan to make a business work. You can bootstrap by funding your growth with sales. But many times the fastest way to scale a business to where you want is to get an infusion of cash that can fuel your expansion.
How Borrowing Can Still Go Wrong
Just because you’re borrowing for one of the reasons described above, doesn’t mean you’re making a smart move. Those three categories—when executed well—are evidence that debt isn’t always dumb. But debt is always dangerous.
Borrow too much, or pick a bad investment and you’ll learn the hard way.
Here are some of the traps of the kinds of borrowing we’ve been talking about
Education has been something of a religion in America for my whole life (and probably a lot longer).
When you combine the worshipful reverence of the economic benefits of education with the government’s decision to guarantee student loans, it means that Universities have licenses to print money. And they do.
Tuition has stayed well ahead of inflation because people will pay anything for a college degree, and the government makes sure they have access to all the financing they need to foot the bill.
This is one way to think about what has been happening to the value of a generic college degree over time:
This isn’t meant to be exact, just a general idea of what is happening. Costs have been rising and the value has been falling. I think there are two reasons for the latter phenomenon:
- A college degree is no longer rare and therefore no longer as valuable
- Universities have added many degree paths that do not confer valuable knowledge and skills
That last point seems to be directly related to the rising costs. Demand for degrees has surged, but many kids don’t want to study subjects that the marketplace values. The solution for Universities? Teach them something else.
I want to be clear on two points here:
- I don’t think we’ve reached the point where the average degree is more expensive than it’s worth, but that’s clearly where we’re headed
- Even if the average degree is worth less than the average cost, you can still win with college by getting a more valuable degree at a cheaper price
When it comes to borrowing money to buy a home for yourself, there are lots of places you can go wrong. But one of them is so much worse and so much more common than the others that it’s the only one I’ll list:
It’s a bad idea to borrow money to buy a more expensive house than you can afford.
How much you can afford is a topic for another day. Right now I’ll just give you the bad news up front and say that if you go with the general consensus of what you can afford you’ll be just as broke as everyone who follows the general consensus.
Starting a Business
This is the one that you already knew was risky. The short version is that the business could struggle or fail and the loan could drive you out of business.
The Kind of Borrowing That’s Best Avoided
- Pay day loans
- Carrying a balance on credit cards
- Investing on margin
The Power of Debt
When used correctly, debt acts like a force multiplier. Your wealth-building is accelerated by having the cash to expand your capacity to make money. You are able to purchase the tools you need before you can afford them.
But just like debt can amplify your gains, it can amplify your losses as well. To win at personal finance, you need to remember to only borrow to build. Even then, you need to remind yourself that debt is always dangerous.