Debt is an interesting economic phenomenon that acts as a double edged sword.
I recently came across an article titled “The Nature of Debt.” It argued that debt is often a burden, but that it does not have to be. That’s true, but the reason is fairly subtle, and has to do with how the debt is used. Most of this article will focus on financial debt. The bulk of the article focuses on when to take on debt. I’m also going to address debt from the other side of the question, looking at the benefits of lending. The last section will look at another kind of beneficial debt: social debt.
I don’t want to get into a very technical discussion, but there is one major concept that needs to be addressed, and that’s expected return. Expected return is is essentially the probability weighted net amount that one expects to receive. It takes into account risk. In reality, one should also account for inflation. Unfortunately most people don’t get into such an involved calculation, but the idea is that expected return should generally be positive. A negative return means that we’re wasting money. Exceptions include things like insurance, which help protect against catastrophic failure.
Debt for Survival vs Growth
Regardless of the reason, taking on debt is an expense. While the is a lower upfront cost, the long term cost is high, especially with high interest rates that are generally given to people with poor credit. Individuals and businesses generally take on debt for two very different reasons. Individuals generally take on debt because they have to, in order to make ends meet. Businesses generally take on debt because they want to grow.
The former generally has a negative return. The latter generally has a positive return. It is for this reason that debt, for most individuals, is a burden. People take out debt and it reduces their overall earnings and wealth outlook for the future, while businesses generally take on debt and increase their long term outlook.
I admit that I don’t necessarily take my own advice nearly as much as I should, but it is important that we choose our debt wisely. Even as individuals, there are cases where we can leverage debt for our benefit rather than for our detriment. Debt consolidation and specific home improvements are two examples. A third example is more complicated. A secured loan, in some cases, may work in a person’s favor, but it’s tricky and risky.
One of the obvious choices is debt consolidation. But even here, one must be careful. The goal should be to reduce the interest rate, and probably the length of repayment as well. A number of online calculators exist that allow a person to quickly evaluate how much the total cost of a loan will be, for given interest rates and repayment lengths. However, most of these calculators do not take into account factors like inflation.
Mortgages can be leveraged for debt consolidation. But home improvement can also benefit our expected return, and also improve our quality of life. Unfortunately quality of life is very difficult to incorporate into financial analysis, but it is something to consider. Mortgages do generally have very low interest rates, and it’s okay to take out a mortgage, if the goal is to leverage that debt for growth rather than existing spending.
Increasing the energy efficiency of a home can drastically reduce monthly utility payments. It also reduces uncertainty about future increases in energy costs, while also making the home more comfortable. Mortgages really shouldn’t be used for general repair however. General repair should be a normal part of monthly spending, so taking out a mortgage for repair throws us right back into the using debt to survive category, making the debt a burden.
Maintenance should be funded through savings. Improvements can be funded through mortgage. That’s why every person should have a reserve for things like fixing leaks, repairing a roof, and other similar jobs. Mortgages should be left to adding better insulation, building an addition, putting up solar panels, getting a backup generator, and other similar jobs.
Mortgages are one form of secured loan, but there are other forms of loans that require one to put up collateral in order to get the loan. Because collateral can be used in place of cash for repayment, interest rates are generally lower. There are exceptions, such as pawn shop loans, which generally have very high interest rates. Usually, the easier it would be to sell off the asset, and the less volatile the market value of the asset is, the better deal a person can get for such loans.
An emerging class of secured loans are short term crypto loans. Constant is one example. It offers a lot of options for borrowing against crypto, including Bitcoin, Ethereum, and a number of ERC-20 tokens. If you’re interested, it also has a referral program, so please use my referral link.
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Why use Constant and why borrow against crypto? Here’s the thing. Crypto is volatile. For this reason it isn’t the greatest collateral. But it is also highly liquid, so it improves its utility as one. There are also times when a lot of cryptoassets are down, and expected to go back up. Borrowing against crypto may be expensive, but it can still result in a net gain over selling the asset, or letting it sit around waiting for it to go back up.
However, once again, the important idea is that loans should not be undertaken in order to pay for expenses. The best use for crypto backed loans is temporarily converting crypto to cash, and using that cash, rather than one’s own cash reserves.
So far all I’ve mentioned in terms of debt is taking on debt. But more and more people are able to engage in lending, thanks to the various peer to peer lending services that are emerging. Traditional ones like Lending Club are a good option. However, just as a person can borrow against their crypto on platforms like Constant, they can use those kinds of platforms to loan. And loaning out money, if done properly, can give a lot of extra income. Loans can yield 10% — 30% APR, and if a person diversifies between loan types and lenders, which is easier to do with P2P lending, they can reduce their risk considerably.
While debt is generally monetary, there are other forms of debt, and they can be very useful. By social debt, I mean things like favors and agreements, that are generally non-monetary in nature, or at least which do not constitute explicit loans. Entire articles can be written on social debt. Starting with social debt which is similar to financial debt, a person can do work for another person, in return for a promise to help them out in the future. Small businesses can take advantage of this kind of system a lot, giving their services to another business in return for credit. Both parties can end up with a better deal, than if each paid cash on the spot.
General favors are also useful. Helping out friends, and helping in the general community, can yield a degree of social debt, that people will feel obligated to pay back. It’s not a guarantee in these cases, but it can be very useful if you find yourself in a time of need.
Disclaimer: I am not a professional financial adviser or anything of the sort. These are my own ideas. Use any information provided in this document at your own risk.