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5 ways to make your debt work for you
Do you manage your debt, or does your debt manage you? The trick is what you use debt for and how you pay it off.
By Jim Jubak
Is all debt bad?
Certainly not. Some pretty good CEOs at some very successful companies have used debt, and plenty of it. General Electric (GE, news, msgs), Johnson & Johnson (JNJ, news, msgs) and Wal-Mart (WMT, news, msgs) all owe billions. So does Warren Buffett's cash-machine Berkshire Hathaway (BRK.B, news, msgs).
So maybe it's just credit card debt that's bad. That's certainly what a chorus of personal finance gurus would have you believe, as they incessantly intone, "Cut up your credit cards! Cut up your credit cards!" And certainly, consumers do have a tendency to run up too much debt, often at unbelievably high interest rates.
But maybe the fault isn't with debt, even with credit card debt, but with how we use it. Most consumers, I'd argue, don't manage their debt; instead they let their debt manage them. Often the only active management we apply to our debt is deciding what credit card bill to pay first and whether to make anything above the minimum payment.
If we managed our debt the way that the best CEOs manage debt, we'd be in control of our debt instead of the other way around. What the best CEOs know is how to get the most out of the debt. They make debt pay.
Here then, are five simple rules to make your debt pay in 2005:
Divide your debt with a capital budget
Draw up a separate capital budget that distinguishes between debt used to buy productive assets and debt used for day-to-day operations. For instance, a mortgage belongs in the capital budget. This is debt that you take on to pay for a place to live, and that asset throws off substantial benefits: savings on rent, tax breaks and potential capital appreciation.
I'd also place in this category a computer that you use for a home business, a car that provides transportation to a better job, or tuition for classes that improve your work skills.
The distinction isn't between tangible and intangible assets -- nothing is much more intangible than education. It's between spending that will produce incremental new income (what we call revenue when we're talking about a business) and spending for consumption that may be pleasurable, fun, even essential, but that doesn't add a dime to the household income stream.
Drawing up a capital budget can be tricky. You can't put the cost of a BMW in your capital budget on the grounds that it is essential transportation. But I think if you're honest, you can come up with a reasonable division of your debt between household capital investment and capital consumption.
Don't pay off that hamburger over 12 months
Match the duration of the debt to the life of the asset, whether it's on the capital investment or consumption side of the budget. You shouldn't be adding long-term debt to pay for short-lived consumption, for example. Eating a hamburger today and paying for it over the next 12 months is a mismatch and a sure sign that you're using debt to paper over a real problem with your budget.
Related resources on MSN Money
Current consumption should be paid out of current cash flow. It's all right to use a credit card to pay for current consumption, but only if you pay off that debt faithfully before it incurs interest. Violating that rule is the most common way that consumers get into trouble with credit card debt.
On the other hand, it makes sense to take on a 15-year or 30-year mortgage to buy a house that will be not only around in 30 years, but almost certainly more valuable then than it is now. And it's even reasonable to take on debt to buy that new computer or business suit as long as you pay off the debt within the life span of that asset, even though the value of that asset is falling every year. It's called depreciation in the business world.
Pay off debt with a sinking fund
Set up a sinking fund to pay the debt for those long-lived assets in your capital budget. Mortgage lenders do this automatically for borrowers (unless the mortgage is one of the new interest-only loans). Each month's payment includes not just interest on the debt, but a payment toward the principal of the debt. Make all the monthly payments and at the end of the mortgage, the principal has been paid off, too.
The point here is to pay for even productive assets during their useful lives and not to turn your capital budget into an excuse for an ever-increasing debt load. If, when you buy a new suit for that next promotion, you're still paying off the last suit, you are in just as much credit trouble as if you were running up your credit card tab to pay for groceries. Figure out when you expect to buy a new suit or a new computer, and make payments above the interest charges large enough to pay off the debt before the asset needs to be replaced.
In more conservative times, companies set up sinking funds to pay off their debt. Now CEOs just assume that they'll be able to roll over the debt when it comes due into new borrowing. That works until it doesn't, as companies such as Lucent Technologies (LU, news, msgs) and Nortel Networks (NT, news, msgs) learned in 2000-2002.
Drive down the cost of borrowing
Increase the profit you earn on each capital investment by driving the cost of borrowing as low as possible. Don't use debt to make investments in productive assets if the spread between the cost of borrowing and the increase in your income isn't in your favor. If the capital investment doesn't make a profit after you've deducted the cost of interest on the debt, you probably shouldn't make the investment at all, and you certainly shouldn't use debt to pay for it.
Good CEOs go through an exercise that requires every item on the capital budget to jump this profitability hurdle. If borrowing money isn't going to increase the company's profits, then why take on the debt in the first place? The two keys here are being honest about the extra income the capital investment will bring in and getting the cost of the necessary debt as low as possible.
This is why companies with better credit ratings such as Berkshire Hathaway, Johnson & Johnson and American International Group (AIG, news, msgs), have a distinct competitive advantage. Because they are better credit risks, they wind up paying lower interest rates to borrow than competitors do. Consumers aren't rated by Standard & Poor's or any of the other credit rating agencies: Instead they have credit scores put together by companies such as Equifax (EFX, news, msgs) that tell mortgage, home equity and credit card lenders how much interest to charge.
Click here to get your credit score. You can increase your personal "spread" between incremental income and interest expense for any capital budget item by managing that score, by finding a lender willing to charge a lower interest rate or by switching from one type of debt to another.
Keep working at it
Never relax. Managing that spread is an ongoing task. Very few kinds of debt actually come with a fixed interest rate these days. Fixed-rate mortgages are actually the exception. Most credit card interest rates, even those that don't have interest rates called adjustable, will rise rapidly if you miss a payment, are late with a payment, run up debt above your credit limit or show a deteriorating credit score.
Credit card companies are constantly tightening their standards. Why? Well, they certainly want to make sure that as few as possible of their customers will default. But more importantly, every time a "violation" moves a customer to a higher interest rate on an outstanding balance, the credit card company improves its own profit spread.
Managing your credit costs -- and keeping your own profit spread as wide as possible -- means constantly looking for the best deal. Increase your profit spread by switching to a home equity loan from credit cards. Increase the spread by taking up the best low-rate teaser offers that you're sent -- and move on to new offers when the teaser term expires. Use balance transfers when the interest rate improvement is enough to offset the balance transfer fee. Negotiate with your credit card companies for lower rates from a position of strength after you've made a substantial payment on a balance used to buy a capital asset.
Hard work? Yes, but worth it
If all this seems like a lot of work, it is. But you don't have to turn yourself into a credit and budgeting maniac to get at least some of the benefit of these five rules. Even the best-run corporation isn't paying the least it can in interest all the time, and even the best don't always get their capital budgets right all the time. But they do make their debt work hard for them. And, if you apply most of these rules, most of the time, you can make your debt work hard for you too.
If you don't want to go through all this effort, you can always save and then pay cash. That works pretty well too, I'd say.
In my next column I'll show how the U.S. government fails at every one of these five basic rules of household debt management. You and I would be ashamed if we managed our debt this badly. But then again, we can't print our own dollars, either.
New developments on past columns
A market-beating financial stock for 2005
U.S. Bancorp (USB, news, msgs) announced fourth-quarter earnings after the market's close on Jan. 18. The bank reported earnings per share of 56 cents, exactly the Wall Street consensus, according to Zacks Investment Research. The bank managed to hold the line on interest income despite a slowing mortgage market: Net interest income slipped just 1% from the fourth quarter of 2003. The bank's strong suit right now, non-interest income, which includes fees for services such as asset and trust, and management, climbed 11% for the quarter. The bottom line also got a boost from a continued decline in the reserves set aside for bad loans. In the quarter, the bank continued to restructure its portfolio, taking a $32 million charge for the decline in value of the company's mortgage servicing assets and a $112 million charge to prepay $2.3 billion U.S. Bancorp had borrowed from the Federal Home Loan Bank.
Editor's Note: A new Jubak's Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Berkshire Hathaway. He does not own short positions in any stock mentioned in this column.
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