Avoid Debt Unless it is to Purchase an Appreciating Asset

I’m generally against debt.  I’ve been debt-free for the past five years.  It allows me to take prudent risks with my investments.  So, when I read things like this in The Economist’s Free Exchange Blog, I shake my head.  Here’s the main quotation:

My friends who study humanities are shocked and do not believe me when I, a pension economist, tell them they should not be saving. Prudent advice has become: You should always save some fraction of your income. You should save not only for retirement, but also for adverse income shocks. But, Mr Becker points out, these new lines of credit help workers cope with income shocks.

The pension economist is wrong, mainly.  So is Dr. Becker.  It is reasonable to take on debt to gain an education for a career that is lucrative; it is not reasonable for something that does not pay well.  Following your heart into a career is a good thing, but if the field doesn’t pay well, don’t saddle yourself with debt to get there.  I know too many young people with large debts in their 20s with no reasonable way to pay them off.  They may be in the field that they love, but they are miserable due to the debt.

It is also reasonable to take on debt for an asset that will appreciate over time at a rate greater than the financing rate on the debt.  Note that I did not say housing here, though that is normally the case.

I counsel all of my kids, and all of my friends to avoid debt where it does not pay, particularly for consumption.  Pay off your credit cards in full each month.  If you can’t do that, cut up your credit cards, and learn to make do without them.

The advantage in life always comes to the man who has surplus, who receives a discount for paying upfront, rather than over time.  You should live below your means, and build up a buffer against the future.  Theoreticians like Dr. Becker essentially say, “Don’t worry, they’ll loan you the money.”  Ridiculous.  First, if they do loan, it is at horrendous rates.  Second, during a credit crunch, all cheap sources of financing disappear for all but the most creditworthy borrowers.  Credit disappears when you need it most.

Saving at young ages sets the tone for the rest of life.  The lifecycle saving hypothesis (of Milton Friedman) is wrong, because most people don’t possess the discipline to switch between being a borrower to being a saver.  Many do it, but not the majority. I saved money when I was a grad student, though most of my colleagues did not.

My advice to you is to develop careful spending habits, particularly if you are young.  What you do now will affect your ability to save for the rest of your life.  Borrow for things that have large long-term payoffs.  Delay purchases for short-term gratification.