Rodney Johnson | Wednesday, May 22, 2013 >>
When I bought my daughter a “new-to-her” car a few weeks ago, I did not finance the purchase. I wrote a check.
Ben Bernanke wanted me to take an auto loan. I refused. I just don’t like debt.
But it raised an interesting question: If used responsibly, isn’t debt a wonderful tool right now because of record low interest rates? The answer isn’t as straightforward as it might seem. It depends on who you are… and how you think.
Debt is nothing more than a claim on future income. When a person takes on debt, he is promising to give someone a chunk of the money he earns in the future, plus a little more (the interest) as the cost of doing business today. So really the borrower is paying more in the future for an item than what it actually costs today.
Typically, people use debt to improve their living standard today beyond their current income. They’re trading a higher overall cost for immediate satisfaction. It’s a choice.
Now, there are a few terms in the description of debt above that should catch your attention…
And “higher overall cost.”
Given that debt is a claim on future income, the first question anyone should ask is: What are my prospects for income? The answer for a poorly-educated 22-year-old is very different than it is for a 50-year-old who holds a tenured position.
These two people should have a much different view of debt because the stability of their future income is so different.
However, the 50-year-old could still lose his job, so his view of debt should be different still from that of a 65-year-old living on a combination of an annuity, bond interest, and Social Security. In the grand scheme of things, the 65-year-old has a pretty steady stream of income.
Along with the possibility of losing one’s income is the possibility of growing one’s income. Because payments on debt are typically fixed, if a person’s income goes up while he is repaying debt then the debt becomes a smaller part of his income. This is what most young people count on as they buy cars, homes, stereo equipment, etc.
Yes, money is tight in the first year after the purchase, but when the next raise comes along, things get a bit easier. When people are young, this sort of rationale makes a lot of sense.
If there is the possibility of income falling, then the debt payments – which remain steady – could eat up more of one’s income, causing hardship.
Then there is how people think…
Debt is truly a claim. Some people have no qualms at all about taking on debt. Perhaps they are very confident in their streams of income, or maybe the debt payment is not big enough to cause a problem. For other people, however, it seems the debt gnaws at their very soul. The idea of owing money to someone else makes them almost physically ill. Recognizing which category you are in before taking on debt can save you a lot of headaches.
One final aspect on debt is how people use it…
Is debt really a simple tool judged on its numerical value? Is the potential borrower whipping out a calculator and, armed with interest rate assumptions, estimating the cost of an item over time based on debt payments and comparing it to future income at some rate of increase? Or perhaps the person has the money needed for the purchase in the bank and is estimating what can be earned on the funds and what must be paid on the debt to see if arbitrage is possible.
Hopefully you recognize that precious few people fall into the last category, but you might be one of them. Typically, people who read research like ours are people who are knowledgeable about such things as debt, interest, and streams of income. They are concerned with their own finances and work hard to teach their families about them as well. This pays off handsomely over time, while other people end up taking on debt they can ill-afford to live a lifestyle that remains beyond their financial reach.
Of course, the same people who are capable of taking on debt and handling it responsibly are exactly those who choose to not do so right now, which is exacerbating our current economic woes…and making Ben Bernanke very unhappy.
Ahead of the Curve with Adam O’Dell
Practically one in two (or 52%) of Americans spend more money than they make… at least a few months each year. Some dig into savings to make up the difference. Some adjust their spending downward the following month to compensate.