In Praise of Debt
By David R. Henderson
My view is very different—and it comes from economics. If I were to put it in Polonius’s terms, I would say it this way: “Both a borrower and a lender be.” That is, at some points in your life, it makes sense to borrow, and at other points, it makes sense to lend. In this article, I focus on borrowing. What follows is my case for debt.
This case is not original to me. Famous economist Irving Fisher, in his classic 1930 book, The Theory of Interest,2 makes the case for borrowing at certain points in one’s life. But the wording, context, and examples are my own.
The Economic Way of Thinking, by Paul Heyne, Peter Boettke, and David Prychitko has a nice, pithy discussion of interest rates, borrowing, and saving. The authors write:
Interest is thus the price that people pay to obtain resources now rather than wait until they have earned the purchasing power with which to buy the resources. The best way to think about interest is to view it as the premium paid to obtain current command of resources. It surely is not “the price of money.”
Current resources are generally more valuable than future resources because having resources now usually expands one’s opportunities. Present command of resources will often enable us to do things that cause our earning capacity to increase over time, so that we will have more resources at some future date than we would otherwise have had. When we see such a prospect, we want to borrow. And we are willing to pay, if we have to, a premium—interest—as long as the interest is less than what we expect to gain as a result of borrowing.3
That passage says it well. We borrow to obtain current command of resources so that we have more opportunities. In the above passage, the authors emphasize that borrowing will often enable us to increase our earning capacity. Think, for example, of the college student who borrows so that she can earn a degree that enhances her income. She needs to choose her major carefully so that her degree really will enhance her income, and she needs to be cautious about the amount of debt she takes on and the interest rate she pays. But the point is that debt can enable this aspiring student to get to the next rung, or even to jump a couple of rungs, on the income ladder.
There is another reason for going into debt—sometimes even massive debt—that has nothing to do with increasing one’s earning power. That reason goes back to Heyne et al.’s first point: borrowing to expand one’s opportunities.
How many people, when they buy their first house, do not get a mortgage? Very few. Whether you, like me, live in an area where government restrictions on building have driven house prices through the roof (pun intended) or live in a place like Houston, where house prices are much lower, if you want to avoid debt, you might wait until you’re 50 or even 60 before you buy a house. That’s what my father did, by the way. He bought his first and only house when he was 50. Most of us don’t want to wait that long. If we are in our twenties or thirties, we want it now, or at most a few years from now.
Enter debt. The way to get that house now is to take on a massive debt called a mortgage. This is true even if you don’t expect your future income to be much higher than your current income. In short, the prudent person often does take on debt, even a large amount of long-term debt.
But what about Polonius’s claim that borrowing “dulls the edge of husbandry”—that is, borrowing causes you to save and conserve less? Going into debt certainly can do that and often does. We’ve all heard, and I have often seen, people who keep a new car for three or four years and then sell it to buy a new one on which they make payments for the next three or four years and then do it all again. If you are trying to build your wealth, that’s a bad idea. Many people lack self-control and take on debt without much to show for it. For them, getting into debt probably is a bad idea.
“Taking on substantial short-run debt can be a great way to save for your retirement.”
But borrowing doesn’t have to dull husbandry. Indeed, it can sharpen it. Taking on substantial short-run debt can be a great way to save for your retirement. Really? Going into debt to save? Isn’t that a contradiction? Bear with me.
Every year, most Americans have the option of putting funds aside in regular IRAs, SEP IRAs, or Roth IRAs. An IRA is an Individual Retirement Account. As the name implies, the usual reason to save in an IRA is to put money aside for your retirement. A SEP IRA is a Simplified Employee Pension Individual Retirement Arrangement. People who make self-employed income have a SEP IRA as an option.
The big advantage of saving in an IRA is a tax advantage. For many IRAs and for all SEP-IRAs, the person who uses them can deduct the contribution to the IRA from his or her taxable income. Of course, on the other end, when the person withdraws money from an IRA, he must pay income taxes on whatever amount he takes out. If he withdraws the money before age 59.5 years of age, he must pay a 10% penalty. Contributions to a Roth IRA are not deductible against taxable income. But the big advantage is that withdrawals from Roth IRAs are tax-free.
Consider someone filing his taxes for the tax year 2016. If he wishes to save in an IRA, he will need to fund his IRA by April 18, 2017.4 One little problem: most Americans don’t have the $2,000, $5,000, or $10,000 handy to partially or fully fund one of these tax-advantaged savings vehicles. I rarely have the funds handy either. Yet each year, my wife and I put between $10,000 (in a bad year) and $20,000 (in a good year) into such accounts. How do we do so? We go into short-run debt.
When I get my data together to turn over to my tax accountant, typically in early March, I estimate how much we can comfortably put aside in our IRAs the next month. In a typical year, our joint income is just below the threshold that allows us to fully fund our Roth IRAs. Because of our age, we can legally put up to $6,500 each in a Roth IRA. In most years, that’s a reach, but we often come close. I also put a substantial amount of my self-employed income in my SEP IRA. By tax time, sometime between April 15 and 18, depending on the year, when it’s time to fund all those accounts, I borrow on my home equity line of credit (HELOC). There are many advantages to such debt. First, I can do it without anyone’s permission as long as the amount I borrow is below the limit on my credit line. It always is. Second, the interest rate on my credit line is quite low, currently about 4 percent. Third, the interest is deductible so that, with my marginal tax rate (including both federal and state income taxes), the cost to me of that interest is not 4 percent but closer to 2.7 percent.
For some self-disciplining ideas for paying off your personal debts, see the EconTalk podcast episode McArdle on Debt and Self-Restraint.
I love debt but I hate debt too. I love debt as a tool, but I hate being in debt. So when I see a large balance on my credit line that could be as high as $20,000 in a good year, I pay it down aggressively with amounts that depend on my free-lance income each month. Some months I pay down between zero and $500. A few months I pay down $3,000. By the end of the year, most or all of it is paid. The next year, I do the same thing.
As a result, the average annual balance on my credit line, absent other major expenses, such as a $15,000 draw for a new roof a few years ago, doesn’t change much from year to year. But my savings grow by $10,000 to $20,000 more each year. The net result: even with small increases in my wealth through dividends, interest, and capital gains, my wealth grows.
Now, you could argue that I could simply save for one year and then start putting money in all those IRAs. To that I have two responses. First, that would mean that the first year I did that, I would fail to fund my IRAs. So, for example, when I get to April and haven’t saved, I wouldn’t fund the IRAs until the next year. That means that I would miss out on one year of tax-advantaged saving.
Second, to follow that strategy, I would have to set a target amount of saving and put the relevant amount aside each month for a year. But I know who I am. There’s no urgency to saving because there’s no debt to pay down. Go back to my statement that I hate debt. With that big debt in my face every time I get on line and check my bank account (my HELOC and my bank account are with the same bank), it gnaws at me. I want to pay it down. And I do.
I tell my students that although I can’t tell them how to get rich quickly, I can tell them how to get rich slowly. The above method is how.
I’m in a particularly good position because my income is relatively high and my wife’s and my expenditures are relatively low. So not all readers will be able to do what we do. But the vast majority of readers will be able to do some version of it, tailored to their own circumstances.
The bottom line is that Polonius was wrong. It often makes sense to be a debtor. If you use debt wisely, you can have a nice house and get rich.
Russ Roberts, How Adam Smith Can Change Your Life, New York: Portfolio/Penguin, 2014, p. 146.
Irving Fisher, The Theory of Interest, New York: Macmillan, 1930. I am forever indebted to my late UCLA professor Jack Hirshleifer for insisting that we read the whole of that classic.
Paul Heyne, Peter Boettke, and David Prychitko, The Economic Way of Thinking, 11th ed., Upper Saddle River, NJ: Prentice Hall, 2006, p. 117.
Why April 18 rather than the traditional April 15? Because April 15 is a Saturday in 2017. The deadline would be bumped to Monday, but Monday, April 17 is Patriots’ Day, a state holiday in Maine and Massachusetts. So everyone in the United States has a deadline of April 18 in 2017.
*David R. Henderson is a research fellow with Stanford University’s Hoover Institution and a professor of economics at the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, California. He blogs at EconLog.
For more articles by David R. Henderson, see the Archive.