Alcohol math. Wine multiplies itself by itself. The more you have, the more you are likely to have. And if it’s hard to stop at one glass, it will be impossible at three. Addition is multiplication. ~ Matt Haig, Reasons to Stay Alive
Debt math is exactly like that. The more you have, the more you are likely to have. And if it’s hard to stop early, it will be impossible later.
Economics has a term for this – debt spiral, which is a situation where an individual, or a business, or a country sees ever-increasing levels of debt. This increasing levels of debt and debt interest becomes unsustainable, eventually leading to debt default.
See this chart.
In 2004, at the Berkshire Hathaway AGM, a 14-year old shareholder asked Warren Buffett to share his top finance tips for young people.
Buffett replied –
If I had one piece of advice to give to young people, it would be just to don’t get in debt. It’s very tempting to spend more than you earn, it’s very understandable. But it’s not a good idea.
The big problem with debt is that it is easy to accumulate, but difficult to pay down. Whether you borrow as a business, or an individual.
Now, the reason debt is so much ingrained in our life is because it is older than money. In fact, as per David Graeber who wrote in his book titled Debt, money was probably invented not to help people struggling with barter, but instead to enable nation states to feed their armies, and for individuals to trade debts with one another.
So, how much ever you may want to get away from it, there is a risk of it lurking around the corner that you must watch out for. And also because one of the most lethal characteristics of debt, like drugs, is that it generally starts small, then slowly creeps into your life making you sort of an addict through the instant gratification it generates, and then takes you over.
The worst part is a lot of people take on debt not just to gratify themselves instantly, but also to gratify themselves more, and faster, than their neighbours and friends and colleagues.
Anyways, when it comes to debt and investing, here is a note from Tren Griffin of 25iq that explains it all –
Debt causes many problems, the worst of which is that the magic of compounding is working against you instead of for you. Leverage can also create situations where underperformance takes you completely out of the investing process. Since “staying invested” is a key to financial success anything that takes you out of the process is a very bad thing. As Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” James Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad. When you are leveraged you can run into volatility that impairs your ability to stay in an investment which can result in “a permanent loss of capital.”
In short, the math of debt is almost never in your favour, whether you take it in your personal life or for investing.
And like Matt Haig wrote for alcohol, even with debt, the more you have, the more you are likely to have. Addition is multiplication.
Paying interest on interest is a long-term trap. Avoid it, please!
I completely agree with you. Debt is like a slow sweet poison…at the end it kills you. Tip from me: Never own a Credit card in your life. If you have one, surrender it.
nice article to highlight pitfalls of spending more than what one earns. However, how about borrowing to say buy a house and staying in that? Is it a wise advice to borrow to invest in house in early part of your career? Regards
Yes, the increasing Debt can make Good investment as Bad.
Sir, yours article are very inspiring, they are researched back and very few Intellectuals actually write to enlighten those who do not have any adviser, I have kept folder of all your article. This article over debt is very nice. It would be excellent if you can write some article over how to train brain, as its get tempted easily by borrowing. Why we borrow?, just because we see other people living luxurious borrowed life or its because brain works differently by different people.
Very useful piece of information. As usually, very well- articulated.
Thanks
Thanks for sharing your wisdom. Very nicely explained.
Very good article Sir 👍. Timely your suggestions. We are seeing how big business empires are collapsing due to debt. Thank you!
I had read about good debt in rich dad poor dad.. A debt which is taken to create a asset is good debt. I think such kind of debt is good.. But you are suggesting otherwise.. May I know the logic sir??
Very well written article. Two America’s current leading financial gurus Dave Ramsey( whom you have quoted in your article)is big advocate of debt free investing and Robert Kiyosaki the author of Rich Dad Poor Dad who believes in investing with other money. Which one do you personally agree with?
Hi Vishal
While I broadly agree with your article , it’s probably misleading to state that debt is bad in all cases. Last I read, despite sitting on so much cash, even Berkshire Hathway is selling debt in Europe because debt is cheaper there. It all boils down to the opportunity cost of capital-whether for a business or an individual.
I find low cost debt to be particularly useful when asset prices are suppressed . Although I never used debt in equities, I have had reasonable success investing in real estate assets that generate rental yield. With lower home loan rates, in some rare circumstances, I found opportunities where rental yield significantly offsets the interest payments on home loans. When the asset prices rebound, there is money to be made on a larger base because of leverage.
I wanted to leave this comment because it took me a long time to come out of the ingrained notion widely prevalent in our society that “Debt is always bad”.
I second your opinion, not all debt is bad. To further support this notion, if you’re earning ROI> cost of debt (Interest rate) then leverage will be beneficial although a double edged sword and in countries like Germany and Japan witnessing negative interest rate, debt becomes a boon.
Is home loan also similar? While it’s good to be zero debt these days for tax and asset reasons most people take home loans, agree it is life time debt some times. Is it good to complete this too quickly and become debt free?
Sir, Nice, crisp and apt article. Debt is a trap and must be avoided. Debt for a deteriorating asset or consumption in hope of ever increasing future (uncertain) incomes is fatal. Debt for acquiring an appreciating capital asset (like property) is still understandable as in the worst case scenario you only have a chance to loose the asset unless market crashes.
Debt can be availed for two types of purposes namely 1. production purpose (when we take debt for purposes like education loan or Assets purchases like home purchases etc.) and 2. consumption propose (when we take debt for buying any consumer goods like smartphones or cars, anything whose value depreciates over a period of time).
Debt for consumption is one of the biggest financial mistake because, whenever we take debt for consumption, we affirm our identity to be ok with spending without earning for frivolous expenses. Eventually, with sufficient repeatations of such transactions, it becomes a habit to spend now and repay later for things and experiences whose value deteriorates.
This is where we hit the debt spiral.
For production expenses, debt should be taken only if the return are appropriate. Eg. If a person is paying a rent of rs 10000 per month and if he can get a loan for purchase of a property for rs 1200000 giving an emi of 12000 per month, then such debt is ok because our net outflow is just 2000 per month for a property whose value may appreciate substantially in future.
Great article sir.
This is only one-sided look on debt.Are there no other perspective about debt?
Although very true for personal finance.
Absolute truth.
We are indebted to You ,Sir.
Regards,
E.Shanmugam.
Very good article Sir but if I may ask is education loan or home loan bad for an individual? That is the only loan wherein the asset never depreciates. With respect to Companies, is it fine if the debt levels are negligible i.e Debt – Equity is less than 1?
In addition,government policies,banks and financial corporations encourage various loans and increase the ever enlarging debt cycle .Though it is necessary for underprivileged students,farmers and entrepreneurs ,they must also be educated about the burden of carrying debt.If i were an educational minister,i will add your post about debt math in academic curriculum.Thanks vishal for adding one more feather in our caps.
Totally agreed with your point. But, I guess only one side of the thing is portrayed that to stay away from debt, because there can be many unforeseen events.
But this dwells down people to never take risk. And for a businessman, for every 1% growth, there is equal amount of risk and fear is present. So not taking risk (that is debt) will never led to new entrepreneurs enter in the market, and then only rich one will have privilege to start new business, which would be totally wrong to portray…..
Instead my perspective says, taking debt is not wrong. It is a kind of risk you are taking and that should be maintained, not to eliminate fully. It’s all risk reward game…
Levereage is always burden and cucumber.But what is solution in time of emergency and need.
Debt is always a huge burden.What is solution in need of an debt for international flight.
True indeed. Debt is like salt. It gives you chasska for a moment but more you consume it becomes harmful for your health.
Thanks for the reminder Vishal !
Please keep producing articles although they seems repetitive, indeed they work like great reminders and stops us from making a mistake.
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Regards,
Amit
I see many comments suggesting that it is not a bad idea to take debt to build an asset (like home loan/mortgage to buy a house). Here is something from the wikipedia page of Dave Ramsey:
Ramsey was born and raised in Antioch, Tennessee. He was a 1982 graduate of the College of Business Administration at University of Tennessee, Knoxville with a degree in Finance and Real Estate.[2] As a real estate investor, doing business as Ramsey Investments, Inc., he built a rental real estate portfolio worth more than $4 million by 1986.[3] The bank that was financing his real estate was sold to a larger bank who demanded immediate repayment on the loans. He was unable to pay, and eventually filed bankruptcy in September 1988.
When you are taking debt (even to build an asset), you are basically selling your future income today to the creditor. And real estate is the most ‘illiquid’ asset class. You won’t be able to sell it in time to raise cash. People actually buy houses on loans to satisfy their emotional need to ‘own’ a house (what will my relatives say, still staying on rent)… and then they try to justify this by saying that they are buying an asset which will appreciate. There is no gaurantee that an asset will appreciate after you buy it. Also, there is no gaurantee that you will have a job to pay off the loan.