Theory: The Only Four Situations Justifying Debt

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Topic Author
DesertMan
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Theory: The Only Four Situations Justifying Debt

Post by DesertMan »

I am trying to craft an investment/personal finance policy statement. Based on my experiences, I think I have come up with a Bogleheadish truism about when debt should be used, and when it should not be used. The answer to debt is always NO, with four exceptions. The only four situations that a person should ever become indebted are:

1. Buying a house. This is the only time that buying a physical asset on credit is a true necessity, as it is unlikely that you can pay cash for a house early in your career. Moreover, unlike all other assets bought on credit, houses tend to appreciate in value rather than lose value to depreciation. Even so, the same amount of money invested in the market has a higher expected return; thus, the mortgage allows you to buy the house without the opportunity cost of taking a large amount of cash out of the market. Home mortgages have lower interest rates than other debt, and the interest may be tax deductible.

2. Financing a remunerative education. College is no longer broadly financially beneficial; having a college degree does not necessarily mean you will earn more over your career after the cost of the degree is factored in, and postgraduate degrees are increasingly required for the higher earning professions. Higher education is only "worth it" if the particular profession you are entering is is in demand and will pay enough to deliver a net financial benefit versus a non-college job that would fit you.

3. Beating a deadline to make retirement contributions or repayments. If you must run a credit card balance or take out a personal loan in order to max your IRA/401k/etc., and you are certain that you will be able to repay the debt quickly, then fine. This can be justified because the debt is paying for a certain benefit, to wit the tax advantage of the retirement plan. Once you have missed the opportunity to make a retirement contribution, it's gone for good. Paying some interest is worth it to avoid losing the contribution. And depending on your tax situation, making the contribution may yield certain benefits like other deductions or credits gained by lowering your AGI/taxable income, or the retirement savers credit. *

4. True emergencies.

Otherwise, the answer to "whether I should take out debt" is always NO. Don't buy depreciating assets like cars or electronics on credit. Don't buy investments on margin, because you are speculating on whether the market will go up or down (and less-volatile assets like bonds are not even going to pay for the margin debit). And do not rely on debt as a substitute for an emergency fund, because the credit may not be there when you need it. Debt is not an asset, it's a liability. You cannot control your fate when you apply for credit. You can "build" credit, yes, but whether that actually will benefit you when you apply for credit depends on many factors out of your control: which FICO score model is used; which credit report; the interest rate environment; the lender's idiosyncrasies. Just don't do it.

* Number 3 is the one that I'm not sure about. I just took out a personal loan in order to do exactly this. I am sure that I will pay it off, but I do not know if this is a wise "policy" going forwards. It feels like investing on margin, even though it isn't; the tax benefit is a certainty, whereas whether margin debt works for or against you is as uncertain as the market, which is why #3 is not speculating, and margin investing is.

Thoughts (on that point, or in general)?
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Re: Theory: The Only Four Situations Justifying Debt

Post by Tingting1013 »

5. Taking out a 1% margin loan for cash needs instead of selling appreciated stock and paying 34% LTCG tax.

6. Taking out a 0% new car loan. Literally free money.

7. Taking out a 1.625% interest only mortgage on a CA house to minimize your investment in home equity which the bank can take away from you in a worst case underwater scenario.
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DesertMan
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Re: Theory: The Only Four Situations Justifying Debt

Post by DesertMan »

Tingting1013 wrote: Sat Apr 10, 2021 12:35 pm 5. Taking out a 1% margin loan for cash needs instead of selling appreciated stock and paying 34% LTCG tax.
Counts as an emergency.
6. Taking out a 0% new car loan. Literally free money.
Not really. If that zero percent offer came from the car company's lender, they baked their profit into the cost of the car. Plus you paid for deprecation.
7. Taking out a 1.625% interest only mortgage on a CA house to minimize your investment in home equity which the bank can take away from you in a worst case underwater scenario.
Do you have somewhere less risky to put the proceeds that will give a net return?
finite_difference
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Re: Theory: The Only Four Situations Justifying Debt

Post by finite_difference »

I don’t know if #3 is worth mentioning in general. Running a credit card balance to invest in your 401k or Roth IRA? It seems like a pretty weird edge case. A lot could go wrong. What if you lose your job?

I also think that taking out a car loan at an interest rate that’s below inflation is not bad debt IF you have already negotiated the OTD price using denovo’s car thread method.
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Re: Theory: The Only Four Situations Justifying Debt

Post by finite_difference »

DesertMan wrote: Sat Apr 10, 2021 12:40 pm
Tingting1013 wrote: Sat Apr 10, 2021 12:35 pm 5. Taking out a 1% margin loan for cash needs instead of selling appreciated stock and paying 34% LTCG tax.
Counts as an emergency.
I think you could expand upon #4 to recommend taking out low interest debt, like this suggestion by Tingting. Or using a HELOC, etc. Or just credit card and paying it off.
The most precious gift we can offer anyone is our attention. - Thich Nhat Hanh
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Re: Theory: The Only Four Situations Justifying Debt

Post by Tingting1013 »

DesertMan wrote: Sat Apr 10, 2021 12:40 pm
6. Taking out a 0% new car loan. Literally free money.
Not really. If that zero percent offer came from the car company's lender, they baked their profit into the cost of the car. Plus you paid for deprecation.
I only buy electric vehicles that don't depreciate after the first year (and sometimes even two) net of tax credits. Then I sell it and buy a new one.
7. Taking out a 1.625% interest only mortgage on a CA house to minimize your investment in home equity which the bank can take away from you in a worst case underwater scenario.
Do you have somewhere less risky to put the proceeds that will give a net return?
This is not the way I look at my housing expense. That kind of framing assumes that owning your house 100% is the natural end state.

My baseline instead is how much it would cost to rent my housing. The problem is that there are lots of downsides to renting. So I go for an interest only mortgage instead. I look at the downpayment as an extra-large security deposit that I will likely get back (and likely get back even more than I put in) if I ever leave (i.e. sell) the house. In the intervening years there is a cap of how high my "rent" (I.e. interest + property tax - tax benefits) can go. And I get to stay in my house and upgrade it as much as I want.

Asking me if there is a positive net return to the money I am not using to pay off the principal presumes that that money is earmarked for the principal in the first place. It is not. It is just my money, for use on general saving or spending purposes.
Last edited by Tingting1013 on Sat Apr 10, 2021 1:09 pm, edited 1 time in total.
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Re: Theory: The Only Four Situations Justifying Debt

Post by KlangFool »

DesertMan wrote: Sat Apr 10, 2021 12:30 pm I am trying to craft an investment/personal finance policy statement. Based on my experiences, I think I have come up with a Bogleheadish truism about when debt should be used, and when it should not be used. The answer to debt is always NO, with four exceptions. The only four situations that a person should ever become indebted are:

1. Buying a house. This is the only time that buying a physical asset on credit is a true necessity, as it is unlikely that you can pay cash for a house early in your career. Moreover, unlike all other assets bought on credit, houses tend to appreciate in value rather than lose value to depreciation. Even so, the same amount of money invested in the market has a higher expected return; thus, the mortgage allows you to buy the house without the opportunity cost of taking a large amount of cash out of the market. Home mortgages have lower interest rates than other debt, and the interest may be tax deductible.

2. Financing a remunerative education. College is no longer broadly financially beneficial; having a college degree does not necessarily mean you will earn more over your career after the cost of the degree is factored in, and postgraduate degrees are increasingly required for the higher earning professions. Higher education is only "worth it" if the particular profession you are entering is is in demand and will pay enough to deliver a net financial benefit versus a non-college job that would fit you.

3. Beating a deadline to make retirement contributions or repayments. If you must run a credit card balance or take out a personal loan in order to max your IRA/401k/etc., and you are certain that you will be able to repay the debt quickly, then fine. This can be justified because the debt is paying for a certain benefit, to wit the tax advantage of the retirement plan. Once you have missed the opportunity to make a retirement contribution, it's gone for good. Paying some interest is worth it to avoid losing the contribution. And depending on your tax situation, making the contribution may yield certain benefits like other deductions or credits gained by lowering your AGI/taxable income, or the retirement savers credit. *

4. True emergencies.

Otherwise, the answer to "whether I should take out debt" is always NO. Don't buy depreciating assets like cars or electronics on credit. Don't buy investments on margin, because you are speculating on whether the market will go up or down (and less-volatile assets like bonds are not even going to pay for the margin debit). And do not rely on debt as a substitute for an emergency fund, because the credit may not be there when you need it. Debt is not an asset, it's a liability. You cannot control your fate when you apply for credit. You can "build" credit, yes, but whether that actually will benefit you when you apply for credit depends on many factors out of your control: which FICO score model is used; which credit report; the interest rate environment; the lender's idiosyncrasies. Just don't do it.

* Number 3 is the one that I'm not sure about. I just took out a personal loan in order to do exactly this. I am sure that I will pay it off, but I do not know if this is a wise "policy" going forwards. It feels like investing on margin, even though it isn't; the tax benefit is a certainty, whereas whether margin debt works for or against you is as uncertain as the market, which is why #3 is not speculating, and margin investing is.

Thoughts (on that point, or in general)?
DesertMan,

I disagreed on all 4.

1) I buy house assuming ZERO appreciation and substantial discount to renting. I took a mortgage knowing that I have the asset to pay it off at any time.

2) No reason to go into debt for college education. I worked at the university. The university paid me plus giving me an in-state tuition waiver. I graduated with 8K of savings. As for graduate education, someone (employer or the college) should pay you for the graduate education. Or else, it is not worth it.

3) Never a problem for me. Always max up my tax-advantaged account.

4) I keep 1 year of expense as my emergency fund. Now, my EF is up to 3 years. In a family of savers, plenty of family members can help out in a big emergency.

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Re: Theory: The Only Four Situations Justifying Debt

Post by smitcat »

DesertMan wrote: Sat Apr 10, 2021 12:40 pm
Tingting1013 wrote: Sat Apr 10, 2021 12:35 pm 5. Taking out a 1% margin loan for cash needs instead of selling appreciated stock and paying 34% LTCG tax.
Counts as an emergency.
6. Taking out a 0% new car loan. Literally free money.
Not really. If that zero percent offer came from the car company's lender, they baked their profit into the cost of the car. Plus you paid for deprecation.
7. Taking out a 1.625% interest only mortgage on a CA house to minimize your investment in home equity which the bank can take away from you in a worst case underwater scenario.
Do you have somewhere less risky to put the proceeds that will give a net return?
- business loan
- rental home loan
- 0% car loan
stan1
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Re: Theory: The Only Four Situations Justifying Debt

Post by stan1 »

Seems like over analysis. Could summarize as don't take out loans unless there is a good business case for doing so. Rent/buy calculators help cover that for home mortgage.
Last edited by stan1 on Sat Apr 10, 2021 1:20 pm, edited 1 time in total.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Svensk Anga »

Car loans are a gray area. We have a 0.9% loan on a Honda. Honda seems not to discount its vehicles but prefers to provide incentives in the form of below market interest rates. When we took this loan 2.5 years ago, we could clearly make more, even after tax, on short term savings than the loan interest rate. I am pretty confident that there was no room to negotiate a lower price. We at least deferred and more likely avoided paying capital gains taxes by taking the loan.

My prior new car purchase was in summer 2009. Paid cash. I hate to think what the opportunity cost was of foregoing financing, given we were still close to the financial crisis low.
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Re: Theory: The Only Four Situations Justifying Debt

Post by DesertMan »

KlangFool wrote: Sat Apr 10, 2021 1:06 pm DesertMan,

I disagreed on all 4.
KlangFool,

I always appreciate your wise contributions. I agree that if you don't have to take out the debt in order to accomplish the goal, you shouldn't do it. But young folks like me are not wealthy enough to avoid doing so; for example, there's no way I could pay cash for a house, and the house is a necessity to raise a family. In some markets, it is possible to rent a suitable house or large apartment instead of buying, but not all. Likewise with education, and so forth.

You're also very blessed to have a close family of savers (who presumably won't expect to buy control of your life with their family loans)... again, not all are so lucky.
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Re: Theory: The Only Four Situations Justifying Debt

Post by tashnewbie »

I’m having a hard time seeing how #3 is relevant in practice in general.

If someone is otherwise able to max tax-advantaged accounts, then I don’t see why they’d need to take out a loan to do so. Even if they could afford to max them, sometimes they may not have sufficient time to do so. For example, if a single has $100k gross income and realizes in September that they should contribute to their 401k, but employer only allows them to defer a max of 50%/pay period. There’s just no way for them to defer the max $19.5k, even by going into debt. If they don’t have such a time constraint, they should be able to max the account in the regular course. If they can’t, then they can contribute what they can and work to increase contribution over time.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Impatience »

stan1 wrote: Sat Apr 10, 2021 1:18 pm Seems like over analysis. Could summarize as don't take out loans unless there is a good business case for doing so. Rent/buy calculators help cover that for home mortgage.
Exactly, no list of rules will cover every possible exception. There’s nothing special about debt that demands such exacting analysis, unless you’re in the business of issuing it or utilizing vast sums of it, it’s enough to just understand the pros/cons and use it judiciously.
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Re: Theory: The Only Four Situations Justifying Debt

Post by KlangFool »

DesertMan wrote: Sat Apr 10, 2021 1:37 pm
KlangFool wrote: Sat Apr 10, 2021 1:06 pm DesertMan,

I disagreed on all 4.
KlangFool,

I always appreciate your wise contributions. I agree that if you don't have to take out the debt in order to accomplish the goal, you shouldn't do it. But young folks like me are not wealthy enough to avoid doing so; for example, there's no way I could pay cash for a house, and the house is a necessity to raise a family. In some markets, it is possible to rent a suitable house or large apartment instead of buying, but not all. Likewise with education, and so forth.

You're also very blessed to have a close family of savers (who presumably won't expect to buy control of your life with their family loans)... again, not all are so lucky.
DesertMan,

<<for example, there's no way I could pay cash for a house, and the house is a necessity to raise a family. In some markets, it is possible to rent a suitable house or large apartment instead of buying, but not all. Likewise with education, and so forth.>>

If I cannot buy, I rent. If I cannot rent more, I rent less. It is a matter of priority. We just have a different set of priorities.

<<You're also very blessed to have a close family of savers (who presumably won't expect to buy control of your life with their family loans)... again, not all are so lucky.>>

Or, we were unlucky. We were oppressed minority in a country where the majority used the government to take away our jobs, businesses, and education opportunities. If we did not help out each other, we would not survive and thrive.

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Re: Theory: The Only Four Situations Justifying Debt

Post by luckyducky99 »

I think it's too rigid.

You can use debt responsibly outside of your list of scenarios (borrowing to grow your own small business; borrowing short term for a large personal purchase that you can afford because it's cheaper than paying taxes on liquidating part of your portfolio). Just like you can use debt irresponsibly within the parameters of those scenarios (buying too much house).

Since you have to analyze whether your use of debt is good or bad anyway, just do that. The situation is kind of... maybe not irrelevant, but a confounding distraction.
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Re: Theory: The Only Four Situations Justifying Debt

Post by watchnerd »

Do futures contracts count as debt if fully covered by cash?
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Re: Theory: The Only Four Situations Justifying Debt

Post by momvesting »

It reads a bit like it was written by someone who has never struggled. I know one time in my life that debt was necessary was immediately after graduating from college. I bought a washer and dryer set with 0% interest because I could no longer do cheap laundry in the campus apartments and commercial laundromats are so expensive. My brother got a great job but needed a car to get there on day one. Sure you can use the “shoulda saved during college” but my brother and I both worked during college to pay for rent and food and there was not much left.
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Re: Theory: The Only Four Situations Justifying Debt

Post by FireAway »

Tingting1013 wrote: Sat Apr 10, 2021 12:35 pm 5. Taking out a 1% margin loan for cash needs instead of selling appreciated stock and paying 34% LTCG tax.
Where does one get these 1% margin loans? My broker is charging something like 9%...
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Re: Theory: The Only Four Situations Justifying Debt

Post by Tingting1013 »

FireAway wrote: Sat Apr 10, 2021 2:12 pm
Tingting1013 wrote: Sat Apr 10, 2021 12:35 pm 5. Taking out a 1% margin loan for cash needs instead of selling appreciated stock and paying 34% LTCG tax.
Where does one get these 1% margin loans? My broker is charging something like 9%...
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Re: Theory: The Only Four Situations Justifying Debt

Post by drk »

There are way more than four situations in the OP, and they could all be distilled: only take out debt if you can reasonably justify it.
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Re: Theory: The Only Four Situations Justifying Debt

Post by aristotelian »

5. Corollary: pay off credit card debt before all other priorities, period (I have seen professional financial "coaches" advocate saving an emergency fund before paying down CC debt).
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Re: Theory: The Only Four Situations Justifying Debt

Post by jjj_22 »

DesertMan wrote: Sat Apr 10, 2021 12:30 pm 1. Buying a house. ... the mortgage allows you to buy the house without the opportunity cost of taking a large amount of cash out of the market. Home mortgages have lower interest rates than other debt, and the interest may be tax deductible.
DesertMan wrote: Sat Apr 10, 2021 12:30 pm Don't buy investments on margin
Saying it's ok to take out a mortgage but not to invest on margin is contradictory.

I could:
- Start with $2M invested, 500K in cash
- Pay $500K cash for a house
- Borrow $400k on margin and invest.

Now I have a $2.4M portfolio, a $500k house, and $400k in debt.

Or I could:
- Start with $2.4M invested, and 100K in cash
- Make a 100K down payment and take out a 400K mortgage for a 500K house

Now I have ... a $2.4M portfolio, a $500K house, and $400K in debt.

Economically, these are equivalent. You can currently borrow on margin at rates lower than mortgage rates; margin interest can also be deductible. There are all kinds of differences in details at the edges, but the principles involved are the same.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Tingting1013 »

jjj_22 wrote: Sat Apr 10, 2021 2:32 pm
DesertMan wrote: Sat Apr 10, 2021 12:30 pm 1. Buying a house. ... the mortgage allows you to buy the house without the opportunity cost of taking a large amount of cash out of the market. Home mortgages have lower interest rates than other debt, and the interest may be tax deductible.
DesertMan wrote: Sat Apr 10, 2021 12:30 pm Don't buy investments on margin
Saying it's ok to take out a mortgage but not to invest on margin is contradictory.

I could:
- Start with $2M invested, 500K in cash
- Pay $500K cash for a house
- Borrow $400k on margin and invest.

Now I have a $2.4M portfolio, a $500k house, and $400k in debt.

Or I could:
- Start with $2.4M invested, and 100K in cash
- Make a 100K down payment and take out a 400K mortgage for a 500K house

Now I have ... a $2.4M portfolio, a $500K house, and $400K in debt.

Economically, these are equivalent. You can currently borrow on margin at rates lower than mortgage rates; margin interest can also be deductible. There are all kinds of differences in details at the edges, but the principles involved are the same.
I think the spirit of OP’s post is not to take out any debt that is “unnecessary”. A home mortgage is “necessary” in a way that margin for investments is not.

Which is false. One could always rent.
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Re: Theory: The Only Four Situations Justifying Debt

Post by jjj_22 »

Tingting1013 wrote: Sat Apr 10, 2021 2:37 pm I think the spirit of OP’s post is not to take out any debt that is “unnecessary”. A home mortgage is “necessary” in a way that margin for investments is not.

Which is false. One could always rent.
Yes I think you're right. That's a good summary. I guess that's what I disagree with. I think debt can be unnecessary but still economically beneficial.
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Re: Theory: The Only Four Situations Justifying Debt

Post by neurosphere »

finite_difference wrote: Sat Apr 10, 2021 12:48 pm I don’t know if #3 is worth mentioning in general. Running a credit card balance to invest in your 401k or Roth IRA? It seems like a pretty weird edge case. A lot could go wrong. What if you lose your job?
I once borrowed $1000 from my mom at 5% interest in February in order to max out an IRA for the previous year, and paid my mom back in June. 22 years later, the interest I paid on that short term loan was well worth it. I'm leaving out the detail where she waived the interest, but the point remains valid.

Or what about someone who over pays their taxes, intentionally, by $5000 in order to become eligible for extra I-bonds. That $5000 was otherwise earning 1% in a savings account. It's a form of "loan" you could say in order to fund an investment "account" that has a deadline of sorts.

Anyway, yes, I realize these are fringe examples. I'm not trying to make any particular point except that "debt" and "invest" can have very broad meanings depending on context.
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Re: Theory: The Only Four Situations Justifying Debt

Post by MJS »

Great question - thank you! Consider:

Use low cost debt to build an inflation hedge. Do you remember the 9-13% inflation of the 1970-80's*? If that returns in the next decade, then setting up 5-10 year's of 1-2% debt is brilliant. Too bad we have an unpredictable future...

* https://www.usinflationcalculator.com/i ... ion-rates/
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Re: Theory: The Only Four Situations Justifying Debt

Post by Doctor Rhythm »

OP, I think your rules are fine, but I’m guessing they are also unnecessarily complex for your personal policy. Unless you often consider taking out a loan for something that isn’t expected to hold or increase in value, you don’t need to get that granular. The discussion on margin investing is interesting, but if you’re not in the very small minority of people who do this, it’s not relevant to you.
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Re: Theory: The Only Four Situations Justifying Debt

Post by JoeRetire »

DesertMan wrote: Sat Apr 10, 2021 12:30 pmDon't buy depreciating assets like cars or electronics on credit.
If someone wants to sell me a car with a 0% interest loan, I'm okay with that.
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Re: Theory: The Only Four Situations Justifying Debt

Post by cheese_breath »

Near death so you won't have to repay it.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Broken Man 1999 »

Debt is simply a tool. You can choose to master it, or you can choose to let it master you. You get to pick.

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Re: Theory: The Only Four Situations Justifying Debt

Post by 123 »

DesertMan wrote: Sat Apr 10, 2021 12:30 pm ...3. Beating a deadline to make retirement contributions or repayments...
If you have to borrow to contribute to a retirement plan or make a repayment you are a lost cause. This situation is clear evidence of a lack of planning and budgeting that is likely an on-going chronic condition. Borrowing "a little bit" to get things right ain't going to work when the rest of one's finances are in such disarray.
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Re: Theory: The Only Four Situations Justifying Debt

Post by UpperNwGuy »

I'm fine with car loans. If you don't have a home mortgage, it provides a boost to your credit score. I think putting $10,000 or more down on the car and borrowing the rest can be good for credit scores without the problems caused by depreciation.
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Re: Theory: The Only Four Situations Justifying Debt

Post by watchnerd »

UpperNwGuy wrote: Sat Apr 10, 2021 3:47 pm I'm fine with car loans. If you don't have a home mortgage, it provides a boost to your credit score. I think putting $10,000 or more down on the car and borrowing the rest can be good for credit scores without the problems caused by depreciation.
But if you have no mortgage and can buy a car in cash, why do you care about your credit score?

We have a good credit score (835), but it's pretty useless if one doesn't ever apply for new credit.
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Re: Theory: The Only Four Situations Justifying Debt

Post by shess »

DesertMan wrote: Sat Apr 10, 2021 12:30 pm 3. Beating a deadline to make retirement contributions or repayments. If you must run a credit card balance or take out a personal loan in order to max your IRA/401k/etc., and you are certain that you will be able to repay the debt quickly, then fine.
Personally, I think this is a real reach. If you are in a position where you cannot afford to max out your retirement plan without taking on debt, then I think it's very unlikely that you can state with any assurance that you'll be able to repay the debt quickly. Is it possible to contrive a case where it might be reasonable? Sure, but rules of thumb shouldn't be based on special cases.

Someone else mentioned having taken such a loan and that years later the gains were well worth the cost. That should ALWAYS be the case with taking on debt, if you expect the long-term value to be less than the short-term cost, you should fight hard to avoid taking on the debt in the first place.

(To be clear, I've taken on debt outside of your list, so it's not that I think debt is so bad. I just don't think your #3 is as reasonable as #2 or #1.)
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Re: Theory: The Only Four Situations Justifying Debt

Post by grabiner »

MJS wrote: Sat Apr 10, 2021 3:08 pm Great question - thank you! Consider:

Use low cost debt to build an inflation hedge. Do you remember the 9-13% inflation of the 1970-80's*? If that returns in the next decade, then setting up 5-10 year's of 1-2% debt is brilliant. Too bad we have an unpredictable future...
Not a good idea; this is essentially market timing. If you borrow in the market, lenders know about expected inflation, and interest rates reflect that. For you to expect to come out ahead, you have to forecast inflation better than the market.

Note that this applies to taking out a loan, not to keeping it. It might be better to pay cash for a house than to take out a 3% mortgage now. But if you have to take out the 3% mortgage, and in a later year, you could pay down the 3% mortgage but current rates are 5%, you don't want to pay it down. This is not market timing because paying down your loan is not a market transaction; the return on paying down a 3% fixed-rate mortgage is always 3% regardless of the market interest rate.
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Re: Theory: The Only Four Situations Justifying Debt

Post by grabiner »

UpperNwGuy wrote: Sat Apr 10, 2021 3:47 pm I'm fine with car loans. If you don't have a home mortgage, it provides a boost to your credit score. I think putting $10,000 or more down on the car and borrowing the rest can be good for credit scores without the problems caused by depreciation.
Taking out a loan to build your credit score isn't likely to be worth the cost. You can get an excellent credit score just by having three credit cards and paying them in full every month; this will be fine when you need the credit record to get a mortgage.

However, a car loan may be a good deal if it is subsidized by the dealer (as several people have posted). And even an unsubsidized loan may be a good deal if it is better than the alternative cost of getting the cash.

I have bought three cars, taking out a loan on the first one. For all three cars, I didn't have enough liquid cash to pay for the car. But for the first car, I would have had to sell stock for a large capital gain to pay cash, so I took out a loan from my credit union instead, then paid it off aggressively. The interest I paid on the loan was less than the capital-gains tax I would have owed on the stock sale. For the second and third purchases, I sold stock for a very small capital gain, and paid no immediate tax because the gain was offset by losses. (As a result, although I had taken a car loan in 2001 and paid it off in 2002, it had dropped off my credit report by the time I took out a mortgage in 2013.)

The important personal finance issue is that too many people take out a loan or a lease in order to buy more expensive cars than they should.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Simple Simon »

OP I completely agree with your four rules. For personal finance.

At the same time, I recognise that many businesses use debt to fund activities which generate higher return.
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Re: Theory: The Only Four Situations Justifying Debt

Post by quantAndHold »

Theory is fine until it meets the real world. When I first got out of college, I took out a loan and bought a new Corolla. I had zero savings and needed reliable transportation to get to work.

A general rule of thumb should probably be that the debt should be productive. As in help you earn money, increase income, grow the business, increase investment, etc.
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Re: Theory: The Only Four Situations Justifying Debt

Post by grok87 »

DesertMan wrote: Sat Apr 10, 2021 12:30 pm I am trying to craft an investment/personal finance policy statement. Based on my experiences, I think I have come up with a Bogleheadish truism about when debt should be used, and when it should not be used. The answer to debt is always NO, with four exceptions. The only four situations that a person should ever become indebted are:

1. Buying a house. This is the only time that buying a physical asset on credit is a true necessity, as it is unlikely that you can pay cash for a house early in your career. Moreover, unlike all other assets bought on credit, houses tend to appreciate in value rather than lose value to depreciation. Even so, the same amount of money invested in the market has a higher expected return; thus, the mortgage allows you to buy the house without the opportunity cost of taking a large amount of cash out of the market. Home mortgages have lower interest rates than other debt, and the interest may be tax deductible.

2. Financing a remunerative education. College is no longer broadly financially beneficial; having a college degree does not necessarily mean you will earn more over your career after the cost of the degree is factored in, and postgraduate degrees are increasingly required for the higher earning professions. Higher education is only "worth it" if the particular profession you are entering is is in demand and will pay enough to deliver a net financial benefit versus a non-college job that would fit you.

3. Beating a deadline to make retirement contributions or repayments. If you must run a credit card balance or take out a personal loan in order to max your IRA/401k/etc., and you are certain that you will be able to repay the debt quickly, then fine. This can be justified because the debt is paying for a certain benefit, to wit the tax advantage of the retirement plan. Once you have missed the opportunity to make a retirement contribution, it's gone for good. Paying some interest is worth it to avoid losing the contribution. And depending on your tax situation, making the contribution may yield certain benefits like other deductions or credits gained by lowering your AGI/taxable income, or the retirement savers credit. *

4. True emergencies.

Otherwise, the answer to "whether I should take out debt" is always NO. Don't buy depreciating assets like cars or electronics on credit. Don't buy investments on margin, because you are speculating on whether the market will go up or down (and less-volatile assets like bonds are not even going to pay for the margin debit). And do not rely on debt as a substitute for an emergency fund, because the credit may not be there when you need it. Debt is not an asset, it's a liability. You cannot control your fate when you apply for credit. You can "build" credit, yes, but whether that actually will benefit you when you apply for credit depends on many factors out of your control: which FICO score model is used; which credit report; the interest rate environment; the lender's idiosyncrasies. Just don't do it.

* Number 3 is the one that I'm not sure about. I just took out a personal loan in order to do exactly this. I am sure that I will pay it off, but I do not know if this is a wise "policy" going forwards. It feels like investing on margin, even though it isn't; the tax benefit is a certainty, whereas whether margin debt works for or against you is as uncertain as the market, which is why #3 is not speculating, and margin investing is.

Thoughts (on that point, or in general)?
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Re: Theory: The Only Four Situations Justifying Debt

Post by rage_phish »

KlangFool wrote: Sat Apr 10, 2021 1:06 pm
DesertMan wrote: Sat Apr 10, 2021 12:30 pm I am trying to craft an investment/personal finance policy statement. Based on my experiences, I think I have come up with a Bogleheadish truism about when debt should be used, and when it should not be used. The answer to debt is always NO, with four exceptions. The only four situations that a person should ever become indebted are:

1. Buying a house. This is the only time that buying a physical asset on credit is a true necessity, as it is unlikely that you can pay cash for a house early in your career. Moreover, unlike all other assets bought on credit, houses tend to appreciate in value rather than lose value to depreciation. Even so, the same amount of money invested in the market has a higher expected return; thus, the mortgage allows you to buy the house without the opportunity cost of taking a large amount of cash out of the market. Home mortgages have lower interest rates than other debt, and the interest may be tax deductible.

2. Financing a remunerative education. College is no longer broadly financially beneficial; having a college degree does not necessarily mean you will earn more over your career after the cost of the degree is factored in, and postgraduate degrees are increasingly required for the higher earning professions. Higher education is only "worth it" if the particular profession you are entering is is in demand and will pay enough to deliver a net financial benefit versus a non-college job that would fit you.

3. Beating a deadline to make retirement contributions or repayments. If you must run a credit card balance or take out a personal loan in order to max your IRA/401k/etc., and you are certain that you will be able to repay the debt quickly, then fine. This can be justified because the debt is paying for a certain benefit, to wit the tax advantage of the retirement plan. Once you have missed the opportunity to make a retirement contribution, it's gone for good. Paying some interest is worth it to avoid losing the contribution. And depending on your tax situation, making the contribution may yield certain benefits like other deductions or credits gained by lowering your AGI/taxable income, or the retirement savers credit. *

4. True emergencies.

Otherwise, the answer to "whether I should take out debt" is always NO. Don't buy depreciating assets like cars or electronics on credit. Don't buy investments on margin, because you are speculating on whether the market will go up or down (and less-volatile assets like bonds are not even going to pay for the margin debit). And do not rely on debt as a substitute for an emergency fund, because the credit may not be there when you need it. Debt is not an asset, it's a liability. You cannot control your fate when you apply for credit. You can "build" credit, yes, but whether that actually will benefit you when you apply for credit depends on many factors out of your control: which FICO score model is used; which credit report; the interest rate environment; the lender's idiosyncrasies. Just don't do it.

* Number 3 is the one that I'm not sure about. I just took out a personal loan in order to do exactly this. I am sure that I will pay it off, but I do not know if this is a wise "policy" going forwards. It feels like investing on margin, even though it isn't; the tax benefit is a certainty, whereas whether margin debt works for or against you is as uncertain as the market, which is why #3 is not speculating, and margin investing is.

Thoughts (on that point, or in general)?
DesertMan,

I disagreed on all 4.

1) I buy house assuming ZERO appreciation and substantial discount to renting. I took a mortgage knowing that I have the asset to pay it off at any time.

2) No reason to go into debt for college education. I worked at the university. The university paid me plus giving me an in-state tuition waiver. I graduated with 8K of savings. As for graduate education, someone (employer or the college) should pay you for the graduate education. Or else, it is not worth it.

3) Never a problem for me. Always max up my tax-advantaged account.

4) I keep 1 year of expense as my emergency fund. Now, my EF is up to 3 years. In a family of savers, plenty of family members can help out in a big emergency.

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Re: Theory: The Only Four Situations Justifying Debt

Post by anon_investor »

stan1 wrote: Sat Apr 10, 2021 1:18 pm Seems like over analysis. Could summarize as don't take out loans unless there is a good business case for doing so. Rent/buy calculators help cover that for home mortgage.
+1.
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Re: Theory: The Only Four Situations Justifying Debt

Post by DesertMan »

123 wrote: Sat Apr 10, 2021 3:40 pm
DesertMan wrote: Sat Apr 10, 2021 12:30 pm ...3. Beating a deadline to make retirement contributions or repayments...
If you have to borrow to contribute to a retirement plan or make a repayment you are a lost cause. This situation is clear evidence of a lack of planning and budgeting that is likely an on-going chronic condition. Borrowing "a little bit" to get things right ain't going to work when the rest of one's finances are in such disarray.
No, it just means you have a family. Children are expensive little unexpected expense generators.

If you can max your retirement every year, you're single, DINK, or a millionaire.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Tingting1013 »

DesertMan wrote: Sat Apr 10, 2021 5:09 pm
123 wrote: Sat Apr 10, 2021 3:40 pm
DesertMan wrote: Sat Apr 10, 2021 12:30 pm ...3. Beating a deadline to make retirement contributions or repayments...
If you have to borrow to contribute to a retirement plan or make a repayment you are a lost cause. This situation is clear evidence of a lack of planning and budgeting that is likely an on-going chronic condition. Borrowing "a little bit" to get things right ain't going to work when the rest of one's finances are in such disarray.
No, it just means you have a family. Children are expensive little unexpected expense generators.

If you can max your retirement every year, you're single, DINK, or a millionaire.
“Maxing retirement” is $39k per year for two working people with 401k plans. I don’t think you need to be a millionaire to save $39k.
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Re: Theory: The Only Four Situations Justifying Debt

Post by LittleMaggieMae »

Otherwise, the answer to "whether I should take out debt" is always NO. Don't buy depreciating assets like cars or electronics on credit.
IDK, The convenience of having a very manageable car payment was worth the $800 in interest I paid (5 year loan). I didn't have "enough" saved up to pay cash for a vehicle I as willing to drive and I was in the early years of "landlording" 2 rental properties - so having more in 'disposable' monthly income from my day job and keeping $$ in savings was important to me (to cover the unforeseen things) than worrying about a low interest loan.

I strongly suspect having to use my HELOC (borrow money at a higher interest rate than the car loan) would have cost me bigger bucks than the car loan - if I stepped up 'savings' and then depleted all my savings to buy a car with a cash - If I had a cash crunch - I would have had to use the HELOC.

Taking the car loan at a low interest rate was worth the "low drama" it bought me over the 5 years I paid on the loan. (I was gonna pay it off 8 months early - but the tiny amount in interest saved made me decide to just let it ride... )

Debt is a tool - which can be used to build wealth (or to decrease drama and stress in life) I would probably work my "financial policy" about that concept: It's ok to take on debt if it makes financial sense in your Big Picture (your goals, your plans, etc).
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Re: Theory: The Only Four Situations Justifying Debt

Post by DesertMan »

Tingting1013 wrote: Sat Apr 10, 2021 5:36 pm
“Maxing retirement” is $39k per year for two working people with 401k plans. I don’t think you need to be a millionaire to save $39k.
Not all households have two wage earners. But for those that do, given the 2020 average US salary of $51,916.27 x 2 = $103,832 gross income. Now subtract from that:

$18,368 average income tax (incuding payroll tax) burden x2 = $36,736
USA average household budget (excluding taxes, savings, and debt service) = $51,100

Total expenses: $87,836, not including state or local taxes.

That's $15,996 left over, again without SALT, and assuming zero debt.

You can't save anywhere near the max in the real world, unless you work your tail off and live well below your means. And even then, it's almost impossible to Max every year.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Tingting1013 »

DesertMan wrote: Sat Apr 10, 2021 7:22 pm
Tingting1013 wrote: Sat Apr 10, 2021 5:36 pm
“Maxing retirement” is $39k per year for two working people with 401k plans. I don’t think you need to be a millionaire to save $39k.
Not all households have two wage earners. But for those that do, given the 2020 average US salary of $51,916.27 x 2 = $103,832 gross income. Now subtract from that:

$18,368 average income tax burden x2 = $36,736
USA average household budget (excluding taxes, savings, and debt service) = $51,100

Total expenses: $87,836, not including state or local taxes.

That's $15,996 left over, again without SALT, and assuming zero debt.

You can't save anywhere near the max in the real world, unless you work your tail off and live well below your means. And even then, it's almost impossible to Max every year.
You way overestimated taxes.

$104k gross income
-$39k 401k
-$25k standard deduction
= $40k taxable income
= $4k federal tax

FICA for a $52k earner * 2 = $8k

Income after taxes and 401k: $53k

Take another $5k off for state income tax (this is definitely an overestimate)

$2k/month mortgage + $2k/month spending is a solid middle class lifestyle.
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Re: Theory: The Only Four Situations Justifying Debt

Post by DesertMan »

Tingting1013 wrote: Sat Apr 10, 2021 7:31 pm You way overestimated taxes.
The Tax Foundation's estimate (it's not mine) assumes the standard deduction, but not deductions for deferred retirement contributions.
$2k/month mortgage + $2k/month spending is a solid middle class lifestyle.
Then why is the Department of Labor's estimate (again, not mine) more than double that? (Hint: try raising a family of four on $2000 a month and see what happens. Not pretty.)

Anyway, let's try to get back to the topic. If you are able to contribute by taking out short term debt which you can repay reasonably quickly, why not?
Last edited by DesertMan on Sat Apr 10, 2021 7:58 pm, edited 1 time in total.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Tingting1013 »

DesertMan wrote: Sat Apr 10, 2021 7:44 pm
Tingting1013 wrote: Sat Apr 10, 2021 7:31 pm You way overestimated taxes.
The Tax Foundation's estimate (it's not mine) assumes the standard deduction, but not deductions for deferred retirement contributions.
$2k/month mortgage + $2k/month spending is a solid middle class lifestyle.
Then why is the Department of Labor's estimate (again, not mine) more than double that? (Hint: try raising a family of four on $2000 a month and see what happens. Not pretty.)
A family of 4 would qualify for at least $6k in child tax credits. Disposable income would probably go up to $3k/month after all is said and done.

It’s not luxurious but it’s definitely doable.
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Re: Theory: The Only Four Situations Justifying Debt

Post by Big Dog »

1. Yes.
2. Yes, but not more undergrad debt than the federal limits. And do not attend a PhD program unless its fully-funded.
3. No way.
4. Sure. (But one man's emergency is another man's morning cappuccino. :twisted: )
5. Yes to car loans.
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Re: Theory: The Only Four Situations Justifying Debt

Post by wootwoot »

KlangFool wrote: Sat Apr 10, 2021 1:06 pm
2) No reason to go into debt for college education. I worked at the university. The university paid me plus giving me an in-state tuition waiver. I graduated with 8K of savings.
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