Wealth Strategy Insights

A Debt of Acknowledgement to Alexander Hamilton

28 October 2016
Alexander Hamilton has been famously misquoted as saying that, “a National debt will be to us a National blessing.” The part many leave off is a key caveat: “…if it is not excessive.” This key distinction begs the question of whether debt, be it a nation trying to grow its economy or a household maintaining a standard of living, can be a good and prudent thing without devolving into a double edged sword.

The U.S. national debt is currently at its highest level since World War II at 104.5%. Historically this ratio has hovered around 65%. However, it helps to put this into perspective. Japan currently carries a debt to GDP of 229.2% and is currently experiencing the unbearable burden of debt servicing that is crushing its ability to grow the Japanese economy. Brazil, on the other hand, has a ratio of 66.23%, and still cannot effectively grow its economy.

By comparison, the personal debt to income ratio for U.S. households is approximately 113%. In Denmark that ratio spikes to nearly 300%. However, the headline numbers do not tell the whole story; debt can be an effective tool for managing growth that is often vilified at the macro-economic level, and the personal level. To put this into context, most Americans do not consider it far-fetched to take out a mortgage for $300,000 on a home (net of down payment) with a total household income of $150,000, effectively putting them at a 200% debt to income level, excluding any other debt they may hold. Not only is this commonplace, it can be considered good practice in that a mortgage helps create a personal “investment” in a tangible asset through home ownership and/or equity, in addition to supporting and growing the economies of local communities.

So what is the distinction between good debt vs. bad debt? The primary differentiator is growth potential. Countries take on debt to help grow or sustain healthy levels of economic growth. Households take on good debt to grow their investments in educating children, obtaining higher paying jobs, or to take advantage of burgeoning real estate prices and/or attractive financing options.

Business owners are keenly aware of the impact debt can have, both good and bad. To acquire a competitor, a small business owner might take on debt with a keen awareness of the growth potential of the investment and the revenue generation it offers. Moreover, that debt oftentimes results in a tax shield (through tax deductibility of interest payments), and academics have long espoused the benefits a tax shield can have on the overall value of a business. In fact, Apple recently decided to take on debt, not because it needed to, but because that debt could be used toward growth investments, offers a tax benefit to their balance sheet, and increases overall shareholder value.

Bad debt can be characterized as unnecessarily taking on indebtedness without a clear purpose toward growth. Financing programs, as in Brazil, that do not tangibly affect growth in education or a citizenship’s ability to obtain higher wages and better jobs is counterproductive. On a personal level, financing short term leisure with debt can be detrimental to your ability to meet more productive goals such as retirement, or home ownership. At a business level, bad debt often manifests through over-leveraging, meaning that businesses take on more debt than their revenues can support. Perhaps with the intent of growing the business, but doing it at a pace that may be too aggressive.

Debt can be a blessing, if approached prudently and with a specific goal toward growth. Whether at a national level, business level, or personal level, debt can be a very good and valuable investment in the future, “… if it is not excessive.”

Sources: http://www.tradingeconomics.com/united-states/government-debt-to-gdp and https://data.oecd.org/hha/household-debt.htm

Opinions and estimates offered constitute our judgment and are subject to change without notice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing