"The rich rule over the poor, and the borrower is servant to the lender" - Proverbs 22:3, New International Version
As I discussed in Chapter 1, we live in a world saturated by advertising and marketing. In addition, a strong culture has developed around the idea of instant gratification. Combined, this leads to the concept for our second chapter, "I Want it All, and I Want it Now!"
At least for a period of time, it actually becomes possible to satisfy the desire for instant gratification even if one truly does not have the means to do so. This is because of the mechanism known as debt. Basically, debt allows you to purchase something that you cannot fully pay for from current income or savings.
Debt - The Big Picture
It is not my intent to demonize the concept of using debt, or cast it in a negative light. Used properly, debt can be a very powerful, and even necessary tool. Used improperly, however, debt has the potential to inflict almost limitless financial damage. Sadly, this can in turn lead to emotional damage in the form of extreme stress if a person reaches the point that they literally cannot repay the debt they have incurred. My goal here is twofold; 1) to show you the difference between the two, and 2) to do it clearly enough that it motivates you to use debt positively, and not detrimentally.But let's return to that concept of debt allowing you to purchase something that you cannot fully pay for from current income or savings. Perhaps the simplest example of the positive benefits of debt is that of buying a home. In many ways, buying a home is more advantageous financially than renting. In the USA, many tax breaks are available to homeowners that are not available to renters. Even if there were no tax breaks, over time one can build up equity in a home which one never achieves by renting.
However, how many people do you know that could purchase a home with cash? Generally, this is an option only for the very wealthy. While housing prices and income vary, let's say for argument that a median-priced home in the USA costs something in the area of $250,000, and that an average annual income is perhaps somewhere in the area of $50,000, part of which must be used for food, clothing, transportation, and other needed things.
So, with an income of $50,000, only a portion of which can be spent on housing, how does one ever afford that $250,000 home? The answer is debt, in this case in the form of a mortgage. A very traditional mortgage is the 30-year fixed rate mortgage. In general such a mortgage can be obtained with a down payment of 10%. On a $250,000 home, a down payment of $25,000 would leave you with a mortgage of $225,000. As it happens, at an interest rate of 6%, your monthly payments would be $1,348.99. With a gross income of $4,167 per month ($50,000 ÷ 12), that would equal 32.4% of your gross monthly income, a ratio acceptable to many lenders.
In the above example, debt becomes a very powerful tool. Used correctly, it allows a person to purchase something for which they do not have enough cash--in this case a home to raise their family--by allocating a reasonable portion of their expected future income over many years to paying off the debt incurred. Please note one important point for now; the debt incurred matched the asset for which it was incurred. In other words, that home should still be around, and in fact will likely have appreciated in value 30 years from now, the point at which the debt will be repaid.
Positive Use of Debt
The above example of a mortgage makes it clear that debt does have a place in the financial lives of most people. While everyone has different circumstances and must make their own specific decisions, here are a few general characteristics of positive debt:1. The payments can reasonably be expected to be accommodated in your current and expected income - We'll delve more deeply into the concept of developing a budget in our 3rd chapter. However, for now we will just state it this way; you must be able to clearly identify how you can realistically repay the debt within the parameters of your current and expected income. This is the key point that hurt many who accepted Adjustable Rate Mortgages (ARMs) to purchase homes that were really beyond their means. Adjustable Rate Mortgages typically offer an interest rate at the outset of the loan that is lower than an equivalent fixed-rate mortgage, but then "catch up" by raising the rates at various points later in the life of the loan, generally with a "cap" higher than the fixed-rate mortgage.
Return to the above example. If an individual was able to obtain an ARM with an initial "teaser" rate of 2%, they could borrow $365,000 and have an initial payment of $1,349.11, almost identical to the $225,000 fixed-rate mortgage at 6%. The additional $140,000 would certainly allow them to purchase a much nicer home, or one in a more upscale neighborhood. However, it would not be uncommon for such a loan to be "capped" at perhaps 8%, higher than the competing fixed-rate loan. In other words, the benefit of the "starter" rate comes at a price down the road. If you think about it, this makes sense, otherwise everyone would take the ARM as opposed to settling for the fixed-rate loan. The problem is that at 8% the monthly payments could jump as high as $2,678.24! Your income would need to nearly double to almost $100,000 to keep the higher payments at the same comfortable ratio of approximately 32-33% of your income. Here's the key question: Do you realistically expect that this will actually happen? If not, chances are that you are making a major mistake.
There are some circumstances where an ARM can genuinely prove beneficial, such as if you know you will have to move before the rates reset sharply upwards. The key point I am trying to make here is that you need to understand very specifically the risks you are taking on.
2. The term of the debt matches the life of the asset - As an example, a 5-year loan is typically appropriate if purchasing an automobile, because that automobile, if well cared for, will have some value at the end of 5 years when your loan is repaid. In contrast, deciding to pursue a "cash out" refinancing of your home using a 30-year mortgage so you can buy that fancy car you always wanted is generally not wise, because that automobile will likely be worthless long before the repayment of that loan. If you are going to take on extra mortgage financing, better it be used for a well-planned remodeling effort that will raise the market value of your home by a roughly equivalent amount.
3. The debt may actually serve to enhance your future income - Student loans could fall into this category. We'll discuss this shortly.
4. In comparison with other choices, the debt finances a necessary item that provides a meaningful benefit to your life - There may be occasions when taking on reasonable debt to purchase a quality item as opposed to something of inferior quality and durability may be a tradeoff worth considering.
With those basic points in mind, let's consider a few potentially good uses of debt:
- Student Loans - Depending on your family's income level and circumstances, it may be necessary to take on a certain level of student loans to finance your education. If the evidence points to the likelihood that your chosen education will lead to a substantially higher level of income, as well as the intangible benefits of spending your life working in a field you enjoy and in which you can succeed, such student loans may turn out to be very good investment.
- Automobile - This one can be a real double-edged sword. I would actually prefer to see you live frugally, save, and purchase a modest car with cash as opposed to taking on debt. However, other factors may influence your choice. For example, if you are required to commute a long distance for work, you may judge that a reliable vehicle that provides good gas mileage may be very helpful, even necessary. If you elect to go the debt route to purchase an automobile, however, my suggestion is that you elect a vehicle that you can pay off in the shortest time possible. Consider a basic vehicle that meets your needs and can be paid off in 3 years as opposed to the flashier vehicle that it will take you 5 or even 7 years to pay off. The "new car" smell and excitement tend to wear off long before the payments are completed.
- Furniture - Particularly if you own your own home, but even if you rent, good quality furniture can sometimes be a better investment over time than flimsy, poor quality stuff that you end up re-buying over and over again. Again, if you make this choice remember to keep the payments within your means and keep the term in alignment with the expected life of the asset you are buying. You should have something of value when the payments are done.
- Home - Again, this is the most common form of debt for most people at some point in their lives. As we discussed above, however, if you want to be able to sleep at night, only buy as much house as you can genuinely afford without having to resort to any sort of "gimmicky" loan. If you find that you need to take on any loan with exceedingly low "starter" rates, an "interest only" loan (which means you are not even initially paying down the principal balance) or, worst of all, any type of "negative amortization" loan (which means your initial payment is not even sufficient to cover the interest, and the principal balance is actually rising), I would strongly suggest you consider why you need to resort to such a loan if you can truly afford the house you are considering. Most likely, the truth is that you can't. It is a virtual guarantee the ending will be bad.
Dangerous Use of Debt
A fundamental danger of debt is that it stands in direct opposition to saving and investing. As briefly touched on in Chapter 1, saving and investing benefits you over the long-term in that you get paid for your self-discipline in the form of interest, dividends and even gain in the underlying value of your assets. In contrast, debt requires that you always ultimately pay more than the actual purchase price. At the end of the day, the whole issue is summed up succinctly and accurately by the Biblical proverb quoted at the beginning of this chapter. The lender reaps benefits and the borrower is, in a fashion, a servant to the lender.
Let's now take a minute to consider some very dangerous uses of debt.
Please consider the exhibit below. As it turns out, Bob is unable to pay for the TV with cash, but has instead charged it on his credit card, which carries an interest rate of 15% on purchases made. Bob has also done a careful analysis of his budget. He finds that, after taking care of key necessary expenses such as his rent, he is only able to make payments of $100 per month. Here is the schedule of interest and principal as he pays off the TV:
Here are some things I'd like you to notice from the exhibit:
Here is the bottom line: The earlier you accept that abuse of credit is a losing game, and adjust your lifestyle accordingly, the better off you will be.
I know what I have written above is tough to take. But I promise you, if you control the desire for instant gratification, live within your means, and budget and save instead, in time you will likely end up being able to own or enjoy all the same things, but on much better terms.
Here is the basic idea: Using debt, you can acquire an amount of assets you could not otherwise. If the value of those assets rises, you can make a killing in percentage terms.
Example: Let's say you have $10,000 that you have managed to save over a 2-year period through hard work and disciplined spending. A good friend turns you on to a pharmaceutical company, with a drug that appears to hold great promise in fighting a certain form of cancer. You believe in it so much that you sink the entire $10,000 into buying shares of stock in the company. Let's assume the drug does marvelously and the stock doubles. You now have $20,000, or a return of 100% on your money. That's good. But look what happens if you leverage. Let's say you borrow $40,000 so you can now invest a total of $50,000. If the stock doubles, you now have $100,000, or a 900% return on your original $10,000! (NOTE: For simplicity, I'm ignoring the fact that you would have to pay some interest on the borrowed money; we'll stipulate that the stock doubled on a major announcement within a very short time). It is certainly true that turning $10,000 into $100,000 could have a very positive impact on your financial life.
Some people have been extremely successful, and become very wealthy, by using debt as leverage as described in that example. Typically, they have worked very hard to become knowledgeable in a given field, the ability to identify opportunities, and the courage to use leverage to benefit.
Understand, however, that while using debt as leverage can lead to huge gains, it can just as easily lead to huge, and even devastating, financial losses.
Let's return to the above example to see how. Let's say that, instead, during the process of clinical trials it is revealed that the drug has unanticipated and serious side effects, and is not approved by the Food & Drug Administration (FDA). Without the benefit of this promising drug, the value of the company's stock promptly drops by 50%. If you merely invested the $10,000 you had in cash, you would have lost $5,000. Certainly, that would not be a happy outcome. But it would not leave you insolvent, you would still have $5,000 with which you could go off and do something else. If you learn a valuable lesson about not "putting all your eggs in one basket" and it only costs you $5,000, you might actually be well off in the long run.
However, if you had leveraged as described above, you would be down $25,000. Since you started with $10,000, not only would you now have lost your entire investment, you would also have to figure out how to repay the additional $15,000 to make good on the $40,000 you borrowed. If it took you two years to save the initial $10,000, that would imply at least 3 years to be able to come up with an additional $15,000. In fact, it would likely be longer, as your lender would want interest on that money. You could easily be looking at 5-10 years of your life being significantly altered in the process of repaying your debt and trying to rebuild your own lost savings, no small matter.
Depending on other factors, you might even find yourself in default, a term you may see from time to time in financial publications, or the business section of your newspaper. You are "in default" when you cannot meet the obligations you agreed to when you took out your loan.
I hope you see the basic idea. Using debt as leverage magnifies both your gains and your losses. If you guess right, you can be on easy street. If you guess wrong, the negative consequences can literally alter the financial direction of your life.
We returned to our friend Bob and his flat-screen TV as a practical example of what debt costs, and frankly discussed where it can, and often does, lead.
We rounded out the chapter by reviewing the concept of debt as leverage, and the potential for outsize gains, but also devastating losses.
In our 3rd chapter, we will turn our attention to creating a budget, as well as creating a Net Worth Report to identify what we truly own.
© 2010 Karl D. Pratt - All Rights Reserved
- Daily Items - It has become a more and more common practice for people to use credit cards for daily, incidental purchases--Starbucks lattes anyone?--as opposed to paying with cash. The danger here is that you quickly lose control of how much you are spending on such items, as opposed to establishing a budget and sticking to it. If the result is that you are unable to pay off your credit card balance in full each month, you will start to incur very expensive interest charges, and possibly fees, for these daily items.
- Discretionary Purchases - In Chapter 1, we discussed constantly changing and evolving technology items. If, on top of feeling like you have to keep up with every change, you are actually having to take on debt to do so, this is going to prove very detrimental financially in the long term. We will discuss this in more detail very shortly. In short, let me strongly suggest to you that, for items such as this, if you can't afford to buy them with cash, you can't afford them. I know, I know, I'm the bad guy. I'm mean. It's OK, you'll thank me later.
- Transient Things - In this category, I am referring to things that are here today and gone tomorrow, while the debt used to pay for them remains. Things like; tickets to your favorite band, heading out on vacation at that fancy resort with your friends, and the like. Now, let me clarify here that I am OK with an occasional exception for a truly life-enhancing or changing event. It may be that you are presented with a genuinely once-in-a-lifetime chance to visit a certain place, or engage in a certain activity, and it may require that you take on a little debt to do so. But please understand that this should be the exception, not the rule. For day-to-day "fun" things, as with discretionary items above, I am going to strongly suggest that you follow my advice in Chapter 3, set yourself a budget, and then stick to it as opposed to taking on debt. If you do, you will find that you are ultimately able to afford an even better lifestyle.
- Living Beyond Your Means - We've already discussed this at length with respect to mortgages. But let me give you one more classic example where people do this; automobiles. You will generally find that if you can afford the payments on, say, a 5-year loan for a Toyota Camry, you may well be able to lease a BMW or Mercedes for roughly the same amount. At first glance, this can seem very attractive. After all, your friends will see you driving this luxury automobile and be impressed, even jealous, right? The problem is, you never own anything, you never build up your assets. Typically, most leases are 3 years, at which point you must either simply turn the car in and start over, or purchase it for some agreed-upon price set at the outset of the lease. In contrast, if well-maintained that Camry will likely last well beyond the 5-year term. If you are smart, you might consider channeling your former car payment into savings at that point. If you do that for 3 or 4 years, you may well be able to purchase your next car with cash and get off the car payment cycle from that point forward. If cars are your thing, understand that there are many individuals who now drive Mercedes and BMWs they paid for with cash, because they had the discipline to chart a course such as I have described above.
A Practical Example
In Chapter 1, I introduced you to our friend Bob. Remember him? He desperately wanted a flat-panel TV, and we discussed what purchasing it would cost him in terms of both how much of his time and effort was required to earn the money for the TV, as well as what the outcome could be if he saved the money instead. I purposely left out of the discussion the implications to Bob if he could not afford to pay cash for the TV, but had to finance it. Let's now expand on that by discussing both the financial cost of doing so, as well as some of the implications if one allows oneself to get trapped in a cycle of using debt to make such purchases.Please consider the exhibit below. As it turns out, Bob is unable to pay for the TV with cash, but has instead charged it on his credit card, which carries an interest rate of 15% on purchases made. Bob has also done a careful analysis of his budget. He finds that, after taking care of key necessary expenses such as his rent, he is only able to make payments of $100 per month. Here is the schedule of interest and principal as he pays off the TV:
- The TV that was originally going to set him back $2,718.70 is now ultimately going to cost him $3,343.03. Put in the context of our earlier analysis, after taxes Bob now has to earn $4,030.17 to buy that TV, or about 161 hours of his work as opposed to our prior figure of 131 hours of his work if he had paid in cash. So, 30 extra hours of work simply to pay the interest! Remember the concept we discussed in Chapter 1; namely that if you saved the money instead, you would actually receive income without having to work for it, in the form of interest? Are you starting to see the contrast in how your life is playing out?
- At a payment of $100 per month, it has taken Bob almost three years to pay off the TV. If by some chance Bob can only afford a monthly payment of $75, it would take him just over 4 years. Here is the worst part: By the time Bob pays off the TV, he will no longer be the envy of his friends. Some of them will have newer models, with bigger screens and more features. This year's Super Bowl party will be somewhere else.
- If you think about it, assuming Bob's income and monthly budget has more or less stay the same, he cannot buy any other similar items until this one is paid off. If he does, he merely digs the hole deeper and deeper for himself.
Here is the bottom line: The earlier you accept that abuse of credit is a losing game, and adjust your lifestyle accordingly, the better off you will be.
I know what I have written above is tough to take. But I promise you, if you control the desire for instant gratification, live within your means, and budget and save instead, in time you will likely end up being able to own or enjoy all the same things, but on much better terms.
Debt as Leverage
Before concluding this chapter, it is worth briefly touching on another concept; that of using debt as leverage to actually gain wealth.Here is the basic idea: Using debt, you can acquire an amount of assets you could not otherwise. If the value of those assets rises, you can make a killing in percentage terms.
Example: Let's say you have $10,000 that you have managed to save over a 2-year period through hard work and disciplined spending. A good friend turns you on to a pharmaceutical company, with a drug that appears to hold great promise in fighting a certain form of cancer. You believe in it so much that you sink the entire $10,000 into buying shares of stock in the company. Let's assume the drug does marvelously and the stock doubles. You now have $20,000, or a return of 100% on your money. That's good. But look what happens if you leverage. Let's say you borrow $40,000 so you can now invest a total of $50,000. If the stock doubles, you now have $100,000, or a 900% return on your original $10,000! (NOTE: For simplicity, I'm ignoring the fact that you would have to pay some interest on the borrowed money; we'll stipulate that the stock doubled on a major announcement within a very short time). It is certainly true that turning $10,000 into $100,000 could have a very positive impact on your financial life.
Some people have been extremely successful, and become very wealthy, by using debt as leverage as described in that example. Typically, they have worked very hard to become knowledgeable in a given field, the ability to identify opportunities, and the courage to use leverage to benefit.
Understand, however, that while using debt as leverage can lead to huge gains, it can just as easily lead to huge, and even devastating, financial losses.
Let's return to the above example to see how. Let's say that, instead, during the process of clinical trials it is revealed that the drug has unanticipated and serious side effects, and is not approved by the Food & Drug Administration (FDA). Without the benefit of this promising drug, the value of the company's stock promptly drops by 50%. If you merely invested the $10,000 you had in cash, you would have lost $5,000. Certainly, that would not be a happy outcome. But it would not leave you insolvent, you would still have $5,000 with which you could go off and do something else. If you learn a valuable lesson about not "putting all your eggs in one basket" and it only costs you $5,000, you might actually be well off in the long run.
However, if you had leveraged as described above, you would be down $25,000. Since you started with $10,000, not only would you now have lost your entire investment, you would also have to figure out how to repay the additional $15,000 to make good on the $40,000 you borrowed. If it took you two years to save the initial $10,000, that would imply at least 3 years to be able to come up with an additional $15,000. In fact, it would likely be longer, as your lender would want interest on that money. You could easily be looking at 5-10 years of your life being significantly altered in the process of repaying your debt and trying to rebuild your own lost savings, no small matter.
Depending on other factors, you might even find yourself in default, a term you may see from time to time in financial publications, or the business section of your newspaper. You are "in default" when you cannot meet the obligations you agreed to when you took out your loan.
I hope you see the basic idea. Using debt as leverage magnifies both your gains and your losses. If you guess right, you can be on easy street. If you guess wrong, the negative consequences can literally alter the financial direction of your life.
Summary and Conclusion
In this chapter, we have discussed debt. I started by defining debt as that which allows you to purchase anything that you cannot fully pay for from current income or savings, and that it can form a positive, and even necessary, component of the financial lives of most of us. I next shared several general characteristics of the positive use of debt, and then examples of both positive and detrimental usage. In the course of doing so, I repeatedly stressed the concept of living within your means.We returned to our friend Bob and his flat-screen TV as a practical example of what debt costs, and frankly discussed where it can, and often does, lead.
We rounded out the chapter by reviewing the concept of debt as leverage, and the potential for outsize gains, but also devastating losses.
In our 3rd chapter, we will turn our attention to creating a budget, as well as creating a Net Worth Report to identify what we truly own.
© 2010 Karl D. Pratt - All Rights Reserved
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