Debt Isn’t a Bad Thing, as Long as It’s Affordable

Yesterday, I wrote that banks starting to lend again is a plus for the economy. Today, I want to take a closer look at a key assumption underlying that statement.

Much of modern society revolves around consumption, and there's nothing wrong with that—if it’s affordable. If not, we find ourselves in 2009 again.

The real question here is what affordable means. In fact, this is the question at the core of saving, investing, retiring, and pretty much everything else I write about here. 

What does "affordable" mean?

An economist named Hyman Minsky defined affordability in the context of asset prices and debt. In brief:

• Affordable debt can be paid off by the asset itself over time—say, buying a condo where the rent can cover the mortgage payments and all the costs.
• Somewhat affordable debt is where the asset can pay the interest charges, but the principal has to be rolled over. Think about that condo with an interest-only mortgage that you have to refinance every five years.
• Ponzi debt is where the asset can’t even cover the interest, but relies on selling at a higher price to someone else to repay. Imagine that condo bought to flip in 2006, by a buyer with no job who couldn’t possibly pay the mortgage.

You can also think about debt in another way: whether it's used for something with future benefits (e.g., a house you live in, which provides shelter as well as potential appreciation into the indefinite future) or immediate consumption (e.g., a luxury vacation, which will pass and vanish). Investment debt provides future benefits and can be economically beneficial over time; consumption provides an immediate boost to the economy at the cost of a long-term drag.

A return to healthy debt

Looking at recent consumer debt trends, much of the spending has been long term and investment oriented—think housing, cars, education. Today, no-doc mortgages are much less common, and borrowers should be able to pay off their loans. This is good debt, and it makes me believe the resumption of lending will benefit the economy. Meanwhile, consumption and unaffordable lending, which would be bad in the long term, remain at relatively low levels.

Beyond the current trends, the broader picture also looks healthy. Household net worth has hit new highs, driven by the stock market and real estate recovery, even as debt has declined. At the same time, low interest rates have made more debt affordable, and debt service obligations remain at low levels.

The proper use of debt is to smooth consumption over time, like the mortgage for the house you live in, or to invest in an asset that will pay for itself over time, such as a college education.

We’ve made substantial strides back toward that proper use. As long as we stay on that path, more debt will be a good thing.