05 August 2012

The Myth of Good Debt and Bad Debt

A friend once told me the following:
If you borrow money to buy an asset that depreciates, this is bad debt, and you should avoid it. If you borrow money to buy an asset that appreciates, this is good debt.
This is crap. One reason is because it's very difficult to actually know whether an asset will appreciate or depreciate. For example, most investors who purchased subprime securities before the GFC wrongly assumed house prices only went up. As a result, borrowing money to buy an asset really only magnifies risk because, if the asset goes down, you lose more.

Another reason why this rule is crap is because it completely ignores the cost of borrowing, the cost of holding the asset, as well as whether the asset generates any income.

For example, suppose you borrow money from a loan shark at 20% in order to buy a house and assume that this house appreciates at 5% per year. You will actually be worse off than if you took out a car loan at 8% and purchased a car that depreciates at only 1% per year. In other words, if the cost of borrowing is so high, it doesn't really matter if the asset appreciates or not.

Some assets may appreciate over time but have extremely high costs. For example, suppose you purchased a run-down apartment that needs constant maintenance. As the landlord you need to fix the showers, clean the walls, replace the tiles, put more concrete on the driveway, and so forth. You may purchase an apartment that appreciates at a mere, say, 1% per year but if it costs you $1,000,000 per year to maintain this apartment, what is the point? These holding costs aren't necessarily in the form of fixing showers and tiles but may include council rates, land taxes, and other taxes or fees.

Another factor ignored when focusing only on asset price changes is the income-producing potential of the asset. If you take out a margin loan with your bank and borrow money at 8% to invest in shares of a company whose stock price depreciates at 1% per annum but it has a dividend yield of 10% then you are better off than someone who takes out a mortgage and borrows at 6% to invest in a house that appreciates at 3% per year and pays rental yield of only 3%.

In summary, if you borrow money to buy an asset, you need to look at a lot more than asset price changes. You need to look at everything that influences on costs and benefits. The idea that borrowing money to invest is a good idea simply because you expect the price of the asset to rise is thoroughly refuted in the examples above. Other things to consider include holding costs, costs of borrowing, and how much income the asset produces.

Chinese Buying Australian Farms

Read more: Sell the farm to buy a future as China's food bowl

There have been worries expressed at Chinese agricultural interests buying Australian farm land. The main issues with this seem to be the idea that the Chinese investor will use the land for Chinese interests rather than Australian interests. Many say that if a Chinese investor owns Australian land and grows food on it, it will export all its food back to China and leave nothing for Australians or it will export so much to China that food prices will rise.

The only thing I have to say to this argument is that it is already happening. It doesn't matter if the farmer is Chinese, Australian, American, or any other nationality. Investors only care about making more money and will export their products to wherever there is highest demand. Australian farmers and especially miners (e.g. BHP) already export significant amounts of agriculture and resources to the rest of the world, especially Asia. To think that simply changing the nationality of the investor will change anything is absurd. If Australians want to limit how much food is exported overseas, it can implement this by imposing trade restrictions on farmers, but this is highly unlikely as politicians should recognise that there are many benefits to farmers exporting their food overseas.

Patriotism is a tool that rich people use to ensure poor people are loyal and obedient to them. When patriotism is not profitable, rich people are quick to drop it. Farmers would love to tell Australians to support the local industry and buy Australian made food as they benefit from the higher demand. But farmers are very happy to start exporting the bulk of their food to other countries to maximise their profits rather than keep it all in Australia to lower prices for Australian consumers.

The same story unfolded in the Australian retail sector. Australian retailers will tell Australian consumers that they need to be patriotic and support Australian products. Of course they will say this because they are making money off the Australian consumer. But the Australian retailers like Harvey Norman, Myer, and so forth have nothing against importing cheap products from overseas, quadrupling prices, and then selling it to gullible Australian consumers.