A lot of bloggers have recently posted about Good Debt Versus Bad Debt. So goes the saying that leverage can lead to higher returns. In a simplistic way they have a point, leverage can be good. However, debt for the purposes of goosing your returns is a bit of a gray area, or Gray Debt as the title of this post alludes. I will write today in the hopes that this information will help you decide on your relationship with debt.
What is Gray Debt?
The basic premise of Gray Debt as a positive is it allows you to earn a return on money that you have not necessarily earned. So, if I have 100K in mortgage, that is 100K in assets I have yet to earn the specific 100K to purchase. Sure you might have 100K sitting in an investment fund allocated for that purpose, but until you use it effectively you have your net worth plus 100K in assets earning you income.
Now, if you were paying more in interest for your loan then your extra 100K in assets returned, we would still be talking about bad debt. You would have a net impact on your finances over time. However, if over time you earned more from that 100K asset then the 100K loan cost you in interest, you have multiplied your income using leverage. Sounds simple, but is it?
How to Create Gray Debt
Let’s start with a simple question. What type of loans would create this leverage situation? We named one already in a mortgage. However, would a 0 percent car loan? Well it depends on if you paid more for the car to get 0 percent. That question is admittedly outside the scope of this post, but it is something to consider. Is taking a loan versus paying cash costing you more in a raised price? It is easy to not consider this point when taking on leverage to goose your returns. We bought a car back in 2015 at 0 percent, but before we did we weighed the difference in a cash negotiation against our expected interest returns. Ultimately our fixed income returns ended up just a slight bit ahead so we went with the loan. However, it is important to check.
Would a student loan? Well does your investment exceed the interest rate of the loan?
Time, Risk, and Gray Debt
We can establish the criteria that the investment has to exceed the loan interest rate, but over what time period? The stock market ebbs and flows but has a historical return in the 6-7% ratio. How long those ebbs last is extremely variable. It could be 1 week, 1 year, or even 10 years. So if you are taking a mortgage and investing it in the market it is hard to tell if you’re creating leverage or costing yourself money. The longer the mortgage the more likely you are to earn a positive return. However, it is still not 100 percent. This is the risk of leverage. It tends to bring more risk to the situation. Returns are of course goosed but there is no free lunch. The risk is instead of essentially eliminating a fixed interest rate debt that offsets any fix rate return you might have, you might end up with a variable rate market return that decreases the value of your portfolio in addition to that fixed interest rate cost.
Which brings us back to our good friend risk tolerance. Gray Debt increases your risk. You need to know if you can handle that risk as not being able to will decrease your likelihood of obtaining the needed return . If you pull all of your investments out of the market after it tanks, then you were probably better off paying off the “Good Debt” instrument.
Liquidity and Gray Debt
An additional point to consider is your liquidity. Can you afford to pay the payment on the loan without tapping your other investments? What if you lost your job would you still be able too? This is exactly what happened to real estate speculators during 2008. They bought huge numbers of houses using high amounts of debt. Essentially they used the equity of the first house to buy a second house, and so on and so forth until their leverage was sky high. Then the market collapsed, both from a job perspective and from a real estate price perspective. They could no longer pay for the next house out of their job income or from a future loan used on the next house. Figuratively the house of cards came crashing down.
Gray Debt and History
Lest you think this is a unique event I recently finished reading a book about the 1929 Great Depression. The book “The Great Crash 1929”, by John Galbraith talks about the causes of the great depression. Chief among them was the usage of leverage. At the time there were market investments called investment trusts. These were not unlike Mutual Funds in some ways, but like hedge funds in others. Essentially banks would buy shares on the market. They would then sell shares of this fund to a subsidiary. The subsidiaries investment was actually the money source for those initial shares. They would then sell shares in the subsidiary to the another entity at a markup which would provide the money to the subsidiary. On and on it would go until the customer at the end purchased the shares of the final trust. Essentially they created leverage at a time when such a thing was not otherwise allowed. The market of course tanked and these large investment trusts went under taking their investors with them.
Which leads to another point. Do you understand how much leverage already exists in your accounts? Are your investments (hedge funds if you’re so inclined but very occasionally for specific exceptions mutual funds) using leverage? What about the individual company whose stock you bought? Are they leveraging debt on their balance sheet heavily to subsidize growth? All this risk is cumulative and something to keep in mind.
Conclusions Regarding Gray Debt
The implication here is gray debt should be employed only if you have sufficient assets and emergency fund to pay the underlieing debt if the proverbial #@$^ hits the fan. Also, you need to go in to the decision with eyes wide open that you are taking on more risk. You could be cool with that, some people are. It is however important for you to consider the ramifications before leaping.
Do you employ leverage in your investing? Do you use Gray Debt to get ahead?
If you have interest in Galbraith’s book I can highly recommend it. I have included an affiliate link above available by clicking the book title for those that are interested. Should you decide to purchase I will receive some renumeration from Amazon.