Debt: Anchor or Sail?

Don't let debt slow you down!

I grew up in New England, and sailing in the Long Island Sound and along the rocky northern coast is among my fondest memories. Regarding sailing terms: An anchor, naturally, is used to limit the movement of the sailboat. It’s heavy, has arms or cups to help it grip the bottom to keep the boat in place. A sail, on the other hand, is used for motive power. By harnessing wind, the sail transmits kinetic energy through the mast to move the boat. The first holds in place or restricts movement, and the second generates power to move forward.

So how does debt relate to an anchor?

One of the most common mistakes in reference to debt relates to the purpose of entering into a particular liability. Using debt to obtain something that only has transient value or which depreciates in value over time is problematic. The payment which covers the initial cost plus fees and interest can far outweigh the actual value of whatever it is.

Not so happy...

Example 1: Most people have heard the example of buying a “Happy Meal” at McDonalds using a credit card. The initial cost is approximately $7 but if that credit card balance is paid over a long period with credit card level interest, the final cost can amount to around $50 or more. The question is then asked, “Is that Happy Meal worth Fifty Bucks?” The obvious answer is, “No.”

Example 2: Financing a vehicle is a very common transaction. Upon acquiring the vehicle, the debtor has to pay the initial cost plus fees and interest. Adding to the liability is auto insurance, fuel, washing, standard maintenance such as oil changes, etc., tires, brakes, wipers and repairs. The reality is that many vehicles do not last much longer than the debt payments, and it is an assumed risk that the vehicle might not even last as long as it takes to pay off the debt.

In the first example, purchasing non-essentials with credit can cause balances to balloon resulting in higher and higher debt payments required to service that liability. This in turn results in reduced funds for essential and non-essential purchases requiring either a reduction in purchasing or dangerous levels of debt utilization. Similarly, in the vehicle financing example, the cost of interest along with all the other liabilities will result in higher and higher risk. The debtor will inevitably reach a point where a vehicle fails leaving the debt still to be paid. Similarly, due to reduced purchasing power, the debtor will be forced into the purchase of a lower quality vehicle thereby increasing risk with predictable results.

Essentially, when debt is used to purchase items or services of temporary value, the reality is that the debt going forward can and will impair the purchasing power of the debtor. In a word, instead of moving forward, the debt will serve as an anchor to keep them in either the same financial situation or land them in an even more constrained one.

So how can debt be a sail?

Many, many, many courses, self-help books and commentators will tell you that wealthy individuals only use debt for purchases that generate value or income. This is perhaps an oversimplification. Limiting your use of debt to purchase income-producing items or property is not easy or frankly advisable. If everyone took that principle too much to heart, there would be a dearth of homeowners, vehicle owners or entrepreneurs. Debt can, however, provide a leg up or boost to wealth generation provided risk is carefully managed.

Plan, plan, plan.

Example 1: After carefully vetting the concept and producing a comprehensive plan, Debtor obtains an SBA loan at reduced interest and develops a business. The plan is carefully followed and updated as necessary, and payments to the SBA are made regularly as a priority to reduce that liability on the balance sheet. After the concept is proven successful, Debtor obtains a second SBA loan to expand and continue to grow. Over time, the business pays off the debt and continues to generate substantial revenue to the benefit of the Debtor.

Example 2: Debtor is shopping for a residence which will be financed. A plan is created documenting costs associated with homeownership including utilities, insurance, debt service, maintenance, repairs and upgrades. Among an array of available properties, the Buyer looks specifically for a property that would meet the planned budget and provide opportunities for generating revenue. Some properties were in high growth locations which could generate value over time based on an increase in property values. Other properties had potential revenue generation like a rentable mother-in-law apartment or space over the garage or a shop or other outbuilding or extra land that could be developed or subdivided. Buyer chooses the best property that falls within the planned budget.

One of the advantages of a capital economy is that debt may be leveraged to enable growth. In the two examples above, knowledge, planning and self-discipline are key elements that allow debt to be used to propel financial growth. Management of risk is a key factor in using debt successfully.

In conclusion: I don’t want to take the sailing metaphor too far. It is true that a sailboat can drag an anchor and still move forward on its journey. Similarly, the wind doesn’t always blow from a convenient angle and so sails don’t always work perfectly… Certain concepts, however, are clear. Indiscriminate spending on purchases of temporary value can result in a debt load that serves as an anchor to retard your progress. Careful, planned utilization of debt can empower your financial growth and propel your success forward.

Curry Andrews, Attorney