Intelligent Borrowing or Stupid Debt

Not all debts are created equal, nor is every type of loan hazardous to your wealth.

The only thing worse than investing in things that depreciate is paying interest on money invested in things that depreciate.

Blaine Harris

Not all debts are created equal, nor is every type of loan hazardous to your wealth.

There is a world of difference between a home mortgage and a revolving credit card balance. Both are liabilities for which the borrower is legally responsible. The first I call intelligent borrowing, the latter is stupid debt.

Those who are living debt-free and are debt-proofing their lives would sooner poke toothpicks under their fingernails than live in the grip of stupid debt. They participate only in intelligent borrowing, if at all.

Intelligent Borrowing

Intelligent borrowing means that some level of safety and limited risk for both the lender and the borrower is built into the transaction. Here is what intelligent borrowing looks like:

1. The borrower has a safety valve — a legally and morally sound alternative to get out of the obligation.
2. The debt is secured. The lender holds something that is at least as valuable as the amount of the loan, something known as collateral. Think of collateral as a security deposit for the lender.
3. The loan is for something that has a reasonable life expectancy of more than three years as opposed to something that will be down the drain before the bill arrives.
4. The loan is for something that will increase in value, unlike a couple of movie tickets and dinner in a fancy restaurant, or a great new outfit.
5. The interest rate is reasonable.

The best example of intelligent borrowing is a real estate loan or home mortgage. Let's see how it measures up to each of the intelligent borrowing characteristics:

1. Is there a safety valve or escape route? Yes, there is a way of escape for both the borrower and the lender. If you, the borrower, find you just can't handle those high payments or you want out for any other reason at all, you can sell the house and pay the lender from the proceeds of the sale. Because the loan becomes an asset for the lender, he can sell his position.
2. Is the debt collateralized? Yes. With a mortgage, the real estate is the collateral — the lender's security. The lender has a legal lien on the property until the mortgage is paid in full, and that gives him a legal position in the transaction. If you as the borrower do not hold up your end of the bargain to which you agreed, the lender may take the property as payment for the outstanding loan.
3. Does the purchase have a reasonable life expectancy of more than three years? Yes, of course. This is true not only for the structure itself but also for the land on which it sits. Buying a home is a long-term investment.
4. Will it increase in value over time? Yes. Real estate is always considered an appreciating asset even though specific values may decline during economic cycles. As a general rule, real estate always gains in value over time.
5. Is the interest rate relatively reasonable? Yes. In nearly all situations, mortgage rates are lower than other types of consumer loans, usually by as much as two-thirds.