Are we in Debt? It’s an interesting and more complicated question then what first comes to mind. Today we will explore what it means to be in Debt and whether we are in Debt.
Defining Debt and Deficit
Lets start with a few definitions. We will use the federal government as an example. There are two things we talk about when we refer to the current government position as in debt. The first is the deficit. This is the concept that in any given year the government spends more than they take in from taxes. In the same way you as an investor can run a deficit, by spending more then you make in any given time period. I have commented before on other posts that I have never run a yearly deficit (unless you count the cost of my house purchase in a single year). As such I am not running a deficit.
Utilizing Debt to Get Ahead
But, conversely you know from other posts we have a mortgage. As such we do have debt. In fact I have more than just a mortgage. I have a car loan that I use for leverage. I purchased a car that I could have paid for with cash with a 0 percent loan in order to invest the difference in low risk alternatives. I essentially arbitraged myself a return by taking that same money and posting it on my mortgage at a then 4.5 percent. This derived a risk free return of about 3.8 percent after taxes. I have explored the pros and cons of this prior in the post on Leverage, so I will not go too far down into the pros and cons. But either way it’s obvious we do have debt. The government has debt as well, over 19 trillion as of this writing.
In Debt Versus Debt
But are we in Debt? Note the word before debt, in. Debt has a connotation in this country. The concept of having spent more than you take in over a sustained period of time. Being in debt to me means not just having debt, but essentially having more debt than assets to pay the debt with. It may not be obvious from my prior post on financial independence, but I have more than enough assets to pay the debt with. Therefore in my opinion we are not “In Debt”. The government meanwhile, by most measures is in debt, but perhaps not all. From a tax revenue perspective the deficit and debt numbers are astronomical. There are some other considerations for the government here we will explore in a moment, but at least per my current definition the government is “in debt”.
Financial Independence and In Debt
Before I move on from the definition of being in debt I want to explore the intersections of the two are we articles. It’s not uncommon for people to equate Financial independence with not being in debt or even having debt. In fact I believe even some of the commenters on the “Are we” article referred to reaching that point after paying off their mortgage along with having a large net worth. The thing is, the two are not necessarily intertwined. On the one hand you can be financially independent and hold a mortgage, thus benefiting from leverage. This would be the positive side of having debt as leverage, and yet you still would not be in debt.
Defining In Debt
But can you also be “In Debt” and be financially independent. Well it depends on how you define Financially Independent. If you mean purely a high positive net worth, then most certainly. Go back to what I said about the definition of “in Debt”. “Having more debt than assets to pay the debt with”. The intersection of a high net worth and In Debt is essentially a liquidity event. A liquidity event is where you might encounter difficulty paying your bills or debts because your assets are not available to pay your debts. This is largely what happened to Bear Sterns in 2008. They had a positive net worth, but since they could not access the value of their assets they could not pay what was due on their debts. As such they went bankrupt.
Liquidity Versus Net Worth
This is also why when talking about asset allocations and investing you always hear mention of needing an emergency fund, regardless of how many assets you have. Even a rich person can declare bankruptcy if they cannot sell their assets to pay their debts. Another great example of this also comes from 2008. During that time period there were many people building real estate empires. Essentially they would use the equity of one home to buy another, and so on until they had both massive assets and massive debts. When the 2008 crash came they had no funds to pay the mortgages on those homes. Also because of the crisis in the country they were unable to refinance the homes removing more equity to help with the loans. As such they lost them in foreclosure. It’s important to remember that not all of the people who lost their homes had a negative net worth, in fact I would guess many had a high positive net worth at the start, but all of them meet my definition of “In Debt”. If you can not readily use your assets to pay your debt, then you are “In Debt”.
Financial Independence and Liquidity
Which brings us to one add to the question of have we achieved financial independence. Liquidity has to factor in to that question in some way. I did not answer that question explicitly in my prior post, but I will now. I could cash in a taxable account and pay all of my debts, regardless of if my home became unsellable. As such my conclusion from the prior post does not change, I am Risk based financially Independent. If my net worth were locked in some vehicle where it was questionable that I could use them to pay my debts in an emergency, then to me by the very nature I could not be financially independent.
Is the Government In Debt?
Which brings us back to the government. The difference between you and me is the government essentially can print more money at will. Of course it will devalue the currency and cause havoc on the financial system, but effectively the government has a license to devalue the debt they owe until the point where they can pay it. As such by some definitions they are not “in debt” because they can produce the assets necessary to pay their bills regardless of the circumstances. Now the political, moral, and even feasibility aspects of those questions are a question for another day or maybe even another blog.
What are Your Thoughts?
See I told you the question of being In debt was a bit more complicated then it seemed on the surface. So now it’s your turn, do you agree with my definition of in debt and my add to financial independence criteria? Are you in debt?
Feel free to check out the other “Are We” series article on frugality here.