Debt: Good, Bad, and In Between

Since the spring of 1995, when I realized some debt can be very good, Sarita and I have not only used a line of credit, we have learned quite a bit about debt . . . and credit.

I have not rejected wholesale the lessons of my youth. Rather, I have learned that the lessons I learned when I was young are good rules-of-thumb. Until you begin to think the way Robert Kiyosaki teaches in his Rich Dad’s CASHFLOW QUADRANT, and you begin to work from the “B” and “I” rather than the “E” and “S” quadrants,¹ those rules-of-thumb have got to be true pretty nearly 100% of the time. . . .

Once you begin to think and act as a Business Owner or Investor, you ought to—you need to—let other factors override the basic rules-of-thumb.

I don’t guarantee that the following factors are in the “right” order. But I hope they help you understand.

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1. There is a major difference between being in debt and having debt or holding debt.

Expressed more accurately—as Garrett Gunderson does in his Killing Sacred Cows, p. 207: “The only time we are in debt, in the true accounting sense, is when our liabilities are greater than our assets, those things that provide income or potential cash flow in our lives.” (Notice, by the way, how Gunderson defines assets along the lines we discussed a while ago.)

Despite making this distinction between debt and liabilities, Gunderson—as virtually all commenters who get into this issue—reverts back to the common use of the term “debt” as referring to virtually any outstanding financial obligation(s) we may have to others . . . whether we have the ability to pay those obligations or not.

Once we distinguish debt (in the sense of being in debt) from liabilities (or having debt or holding obligations to others), we can begin to make some very useful distinctions between the qualities (good and bad) related to debt.

2. Being in debt means lacking the means to pay for your debt; being (at least technically) bankrupt. And that is definitely bad.

If you are in debt like that, you are in trouble. You are, at that point, “slave to the lender.” Until you can get your financial boat “above water,” your labor will go toward fulfilling your creditor’s demands and needs, not to help you fulfill your desires.

Historically, debtors—people who cannot meet their obligations—were thrown in prison, or, indeed, enslaved. In India today, tens of millions of people—men, women and children; entire families—are debt slaves. Here in the United States, at least until recently, bankruptcy laws ensured that, in dire straits, you could escape such debt bondage. At this point in time, however, bankruptcy laws are tightening up, and certain personal debts will remain with you until you die (and may have to be paid off by the assets in your estate when you die). In this regard, I am thinking particularly of private educational loans. A declaration of bankruptcy will not free you from that debt.

3. Having debt or holding debt can be bad (and, for far too many of us, really is bad). But it may be good. Indeed, as I said last time, it may be very good.

Suppose you are not in debt in the sense that I have just described, but you do hold debts or have debts.

I like Gunderson’s scheme for distinguishing three types of such obligations:

• Productive Debt: Liabilities you contract in order to acquire assets that produce more positive cash flow for you than the liabilities consume in negative cash flow. Put another way: you borrow in order to acquire an asset that will produce income for you. The loan costs you x. The income from the asset produces x + y (where y is a positive number).
• Consumptive Debt: Debt that produces no income for you. You contract an obligation with negative cash flow . . . and whatever you buy with that money produces no positive cash flow, or, if it produces positive cash flow, it produces less cash than you need to pay the loan obligations.
• Destructive Debt: Debt that not only produces no income, but that actually destroys your ability to produce value for others—and, therefore, destroys your ability to produce income for yourself.

Let’s analyze these three types of debt, starting from the worst:

Destructive Debt

This is debt you create for yourself in order to engage in self-destructive activities—like consuming substances that destroy your ability to operate at peak effectiveness and efficiency. Maybe they are certain kinds of foods. Or quantities of foods. Drugs. Pornography. Gambling. Cigarettes. Going out to the movies. . . . —The list could go on.

I imagine you might view some of the things I listed as bad in themselves. Destructive in themselves. But with others, you may be scratching your head: What is he talking about? “Going out to the movies”?!?

I included that one in particular because I wanted to point out that it is not the thing in itself, necessarily, that is destructive. It is what that thing—that activity—does to you.

Destructive debt is debt you contract for things or activities that not only cost you money, but that you find tend to control you, that you “can’t stop,” and/or they are destroying you (your body, your relationships, your positive mental attitude . . . ) —they are destroying your ability to be productive, to produce value for others (which yields income for you).

That is Destructive Debt. The absolute worst kind of debt.

Consumptive Debt

This is debt that you contract solely for the purpose of consumption: possibly to meet basic needs of life, but mor likely for most Americans, debt you contract to meet “lifestyle” desires.

Obviously, if your weekly or monthly income (cash flow in) is less than your basic weekly or monthly necessary living expenses (cash flow out), you are engaged in a form of behavior that cannot be sustained forever. At some point, if the imbalance continues, you will run out of resources, and you will find yourself, truly, in debt—incapable of paying what you owe. In other words, unchecked consumptive debt will, in time, “eat you up.”

So the question is: what will you—or should you—do about it?

If you are in a temporarily difficult spot (your car broke down; your house was damaged by a major storm; you or one of your family members is suffering a catastrophic illness; etc.), this kind of debt or liability may be necessary, and—unless there was a way, through proper planning and behavior, you could have completely avoided the expense (through insurance, perhaps)—you should feel no shame in the fact that you are acquiring some temporary consumptive debt.

On the other hand, if you have an uncontrolled habit of buying things that create long-term liabilities² “just because”: “Oh, my goodness! Everything was on sale!”; “I love Apple products”; “All my friends were buying, how could I not?”; “I will look so good in that!”; etc. . . . —it is time you change your consumptive habits.  You will, indeed, consume yourself. Maybe not now. But sometime in the future.

And if you have created such a habit, it is likely you should discipline yourself to say no, to do without, to buy only what you really and truly need . . . until your expenditures are lower than your income.

NOTE: Any time you buy something beyond a certain base,³ you should view your purchase as a form of contracting a liability. You may owe that liability to someone else; you will have to pay that other party interest. But even if you pay for your purchase with cash, you are contracting a liability to your future self. As Nelson Nash writes in Becoming Your Own Banker: You finance everything you buy. In the case where you pay cash, you’re not having to pay up interest (cash flow out), but you’re going to give up interest (cash flow in).

Thus, while it may be possible for you to “afford” certain expenditures today, it is possible that you are unwittingly stealing from your future self: pretending that current expenses are all that matter . . . when it is your future self that will really have to pay. –We will return to this subject at a later date.

Productive Debt

This is the kind of debt—or liability—that, when I was growing up, no one I knew ever talked about.

The closest thing to this kind of debt I ever heard about was when I happened to listen to people who deal in “securities” and those who trade in foreign exchange, commodities, and futures. These people will talk about buying “on margin”; and they will talk about the wonders of “leverage.”

They are talking about borrowing money in hopes of multiplying the impact of your “investment” in these kinds of “instruments” and trades. (“You can ‘control’ a million dollars worth of gold with only $10,000 of your own money!”)

I suppose, if you were some kind of expert in these things, or if you had a super computer that was situated at the right point in the midst of all the trades going on, where you could profit—as the major “investment houses” have their computers situated to profit—off of tenth- or a few hundredths-of-a-cent price differentials in various contracts, such leverage really could be a productive liability that enables you regularly and without concern to multiply your profits.

But for most of us, that kind of leverage is just as likely to impoverish us as it is to gain us any wealth.

Productive debt, I believe, is of a very different sort.

It is like the debt Sarita and I contracted to smooth our cash flow cycle and to enable us to meet our customers’ buying needs. As I explained, it was this liability—our company’s line of credit—that yielded a solid 10-to-1 return on investment. We paid $10,000 in interest to avoid $100,000 of otherwise unavoidable expense.

The bank that loaned us the money and we, the borrowers, had no reason to view our transaction as risky. Rather, we had every reason to believe that the loan would be a win-win-win all the way around: for our company, for our customers, and for the bank itself.

So that debt, that liability, was a good one. It was productive. Indeed, it was massively productive for Sarita and me.

Note. While Sarita and I contracted with the bank, the liability was ours. The bank wasn’t liable. We were.

But while the bank wasn’t liable to us, it was liable to others.

So notice that banks take on productive debt—productive liabilities—all the time.

They borrow from you (currently at a national average of somewhere around 0.12% per annum) and lend your money to others—or maybe to you!—at anywhere from 2.x% (a rate reserved for only their very best customers), to around 3.5% to 4%, perhaps, for high quality mortgages, to 6% or 8% for auto loans, to 13% on up to 24% or higher for unsecured credit card loans.

Talk about “productive”! –This kind of borrowing is the bread and butter, meat and potatoes, and dessert of the banking industry. They love those liabilities they have toward “depositors”! And they use those liabilities to acquire productive assets—assets in the form of loans that they make to others.

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Think through your situation.

• Do you have any Destructive Debts? If so, what are you going to do to eliminate them so that you, too, can become Ready2Prosper?
• How are you doing with Consumptive Debts? Are you free of such debts? Do you need to become free? What will you do to free yourself?
• How about Productive Debt? Do you have some? Can you understand how you might use some?

Next time: How Should You Pay Off Consumptive or Destructive Debts?

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¹ E, S, B and I: Kiyosaki’s book features a matrix composed of four quadrants. You can see the matrix on the book’s cover: “E” (Employee) is in the quadrant on the upper left; “S” (Self-Employed) is in the lower left; “B” (Business-Owner) is in the upper right; and “I” (Investor) is in the lower right.

As Kiyosaki explains, all of your cash flow will come from one or more of these quadrants. And you get to choose your quadrants. You can aim for your quadrants. Most people stay in the “E” quadrant. They think and act as Employees.

Kiyosaki urges—and I agree with him—you are much better off if you can begin to think and act as a wise “B” or “I.” –I intend to address this entire way of thinking some time in the future as well. When you lay hold of Kiyosaki’s message and apply it in your life, it can make a massive difference. Return to text.

² For the purpose of this point, I define a “long-term liability” as anything for which you may be liable for interest payments. I.e., if you can’t pay off your credit card this month, to avoid interest charges, then you have created a long-term liability. Return to text.

³ Base: “I need this, not merely to live, but to be maximally productive (in the sense of adding value to others). I need this in order to fulfill my purpose in life. To fulfill my obligations.” Return to text.