Saturday, December 17, 2016

Debt-to-Equity Ratio in Personal Finance

Debt-to-Equity ration (D/E) is used to evaluate the strength of companies.  Does it make sense as a metric for your personal finances?  Probably not, for a number of reasons.  Financial metrics that make sense for business rarely make sense for you, personally.

A reader writes, asking whether the Debt to Equity ratio (D/E Ratio) has any place in personal finance.   As we discussed before, a lot of things that "make sense" for a large corporation, make no sense at all for an individual.

For example, in an earlier posting on D/E ratio, I used the example of Ryder, Inc.  Ryder is borrowing money to buy trucks, which they in turn lease, at a profit, to trucking companies and truck drivers.   For them, borrowing money makes sense, as they can make even more money by leasing out the trucks.

For the trucking companies, leasing sort of makes sense, in that they want to deliver goods and make money, not run a truck repair shop.  They lease the trucks, deduct the lease expenses (rather than amortize the cost of purchasing a truck) and worry less about repairs and more about delivering goods on time.  They can deduct the lease cost as a business expense.

For us citizens, or "consumers" as the media likes to call us, neither proposition makes much sense.   Borrowing money to buy a car for our personal use is just borrowing money.  We don't come out ahead in the deal, no matter how much the car salesman tell us that the "opportunity cost" of paying cash means we miss out on investment opportunities!   Rather, he wants to sell us more car, and he realizes he can do it, on monthly payments.

Similarly, as consumers, we cannot deduct our lease payments on our taxes, so they are just a personal expense.   And again, a car salesman will make opportunity cost arguments to try to sell you more car.   But these arguments are flawed, as there is no real opportunity being missed here.   For personal finance, business finance arguments make no sense.

So how does Debt-to-Equity ratio apply to personal finance?   It does, and it doesn't.   To begin with, your personal D/E ratio, when very young, could be staggering.   Suppose you graduate from college with student loans totaling $50,000.  You have no assets other than some furniture and a used car worth maybe $5,000 combined.  Your D/E ratio is a staggering 10.0 - enough to bankrupt most companies.   And indeed, even if you are employed, you are technically insolvent at this point in your life.

And that probably describes me, at age 30 or so, saddled with student loan debt, credit card debt, and car loan debt - and not a lot of savings and assets.   My personal D/E ratio was well over 5.0, meaning my debts outweighed my assets by a factor of five.   My net worth was negative at this point.

But as we get older, we pay down some of those debts - or try to, anyway.   And we put aside some money in a retirement plan, and maybe we bought a house that has some equity in it now.  We pay off our car loan and own a car free and clear.   We have $200,000 in debt (home mortgage plus other debts) and maybe $200,000 in assets.  Our D/E ratio is 1.0 - but our net wort is still a big ZERO.

For a lot of people, this is as good as it gets.  As their house goes up in value, they take out more cash in home equity loans or refinancing deals, and their net worth hovers near zero and their personal D/E ratio around 1.0.

But for some of us, life does get better.  We put aside cash into savings, and we pay down debts - without constantly taking on new ones.  We start to establish a positive net worth, and our D/E ratio drops below one.   Eventually, if we become debt-free, our D/E ratio drops to zero-point-zero (or close to it) as we have no debts at all.  Few people seem to be able to do this.

Why is this?

Well, debt does have a function in our lives and in our economy.   As the Ryder example illustrates, a company can use debt to make money.   You borrow a billion dollars, build a factory, and then you made widgets all day long, which pay down the loan and leave a little money left over.   Sure, you could try to pay cash for such a factory, but since it is hard to save a billion dollars, you'd either have to start small and build your way up (which is hard to do, as you don't have the economies of scale your larger competitors do) or you have to sell off a big chunk of your business to shareholders.  Debt can have a useful function in life.

Similarly, for personal finance, debt can be useful, but only for things that would save you money or make you money.   For example, borrowing for a college degree could be a smart way of using debt, provided you don't get a useless degree in "communications" or "racial studies" or some other such naval-gazing nonsense that colleges like to sell these days (and kids lap up, not thinking about where such degrees will lead them - nowhere).   If you borrow money for a worthless degree, that's idiotic.  If you borrow money for a useful degree, that's smart.

A home mortgage can be a smart debt, provided the mortgage is locking in your payments and saving you money by creating equity in a home (as opposed to a string of rental payments).   Over time, your fixed monthly mortgage will seem small, compared to comparable rents.   But if you get a mortgage to buy a "look at me!" mini-mansion to impress people you don't even know, that is just idiotic and will bankrupt you.  Ditto for serially refinancing your house so you can borrow money to cover your living expenses today.

Really dumb debt is consumer debt - consumer loans for a hot tub or a pool table.  Credit card debt.  Even car loans, particularly if they are for a "look at me!" car that is more about showing off than providing transportation.   And if stretched out to seven years or more, or at a high interest rate, doubly dumb.

And the more debt you take on, the harder and harder it is to bring that D/E ratio down.   If you graduate from college with $100,000 in debt - or more - it may be very hard to ever pay off such a debt.

So yes, the D/E Ratio might make some sense for individuals as well as companies. However if you sit down and calculate your debt to equity ratio you might find yourself getting very depressed.

In addition, as with any ratio, it may not be very instructive. For example, if you had debts of $100 and assets of $1,000, your debt to equity ratio would be 0.1 which would sound very good on paper.   However, it would still mean you're essentially broke.

Moreover since your debt to equity ratio changes over the span of your life, it is more an indica of your age than anything. Nevertheless if you were reaching retirement age and your debt to equity ratio is still 1 or higher you may want to think where this is going.