Remember when pundits suggested the way to get rich quick was to use “Other People’s Money” (OPM)? They pointed to real estate empires and stock market success resulting from investors leveraging debt to accumulate wealth. It’s not as easy as it sounds.
I moved to Atlanta during the cable TV boom. Several friends worked for Scientific Atlanta, an innovator in cable TV boxes. They touted their stock; it was constantly doubling and splitting. I cautiously tracked the stock. It went from $16 to $32/share and split and moved up rapidly.
Friends confided they were introducing a new box that would “revolutionize” the industry. I hurriedly took out a second mortgage for $32,000 and bought 1,000 shares. I anticipated another split at $32 and another double. I’d sell, pay off the second mortgage, and take a couple decades off my primary mortgage.
It did not end well. They had a major product recall. Two years later I sold it all for around $16,000, leaving a balance on the second mortgage. Each month, as I wrote the check, I was reminded what a big mistake I made.
Borrowing money to buy assets you feel will appreciate over time makes sense – if you understand the risk and know what you are doing. Banks lend money to businesses providing a business plan that clearly shows how the borrowed capital will improve their profitability. Even then, the best business plan can crumble if something unanticipated happens.
In retrospect, I’m glad it happened. Had my plan worked, I might have been fool enough to think I was smart, and probably tried it again on the next hot stock tip that came along.
Using OPM to buy assets that might appreciate is risky; however, there are far worse uses of borrowed money.
| Using OPM to buy depreciating assets, or consumables has put many people on a debt treadmill that can take decades to overcome. |
What is debt?
Debt is used in determining wealth. What you own (assets), minus what you owe (debt), equals net worth (your accumulated wealth). A person with $1 million in assets and $1 million in debt is broke! I’ve met some incredibly high earning “professionals” at the country club who fit that mold.
Many confided that they felt like they were on a treadmill trying to keep up with the monthly payments. The 1990’s book, “The Millionaire Next Door”, summed it up this way, “Big Hat, No Cattle!”
Debt is borrowed money that must be paid back. Non-payment can have serious consequences. Interest is the rent you pay for holding/using other people’s money (OPM). Generally, the higher the risk of non-payment, the higher the interest rate charged.
Let’s look at different types of debt:
- Auto Loans
- Mortgage debt
- Margin debt
- Credit card debt
Auto loans use the vehicle as collateral. Autos (campers, boats and 4-wheelers) are depreciating assets. It’s difficult to accumulate wealth owning and financing depreciating assets.
Don’t fall into the trap of focusing on monthly payments. You will soon be “upside down” in the loan, owing more than the vehicle is worth. When you trade it in, you will have to borrow more and it can take years to recover.
For more detailed information, please see “If You Don’t Think You Can Afford the Car – You Can’t”.
Mortgage Debt is using your home as collateral. The loan term is generally over a few decades. You HOPE your home appreciates over that time. Some friends in Detroit found that is not guaranteed.
While people may legally own their home, the rent (interest) paid to the mortgage holder can easily double the original cost.
For more detailed information see “Should You Pay Off The Mortgage?”.
Margin debt is borrowing money from your stockbroker in order to purchase shares of stock. Theoretically, you are borrowing money to make money, anticipating the stock will appreciate.
| In theory, there is no difference between theory and practice. In practice, there is. – Yogi Berra |
If you wanted to buy 300 shares of stock – and had money for 200 – your broker will lend you the difference. You pay the interest monthly. When you sell, the broker takes what you owe and (theoretically) you enjoy a larger profit.
If the stock drops below a certain level, your broker is required to issue a “margin call”. Unless you can quickly come up with the money, they have the right to sell assets in your account – above and beyond the stock you bought on margin – to protect their interests.
During the internet boom, many investors bought stocks on margin. If the market turns on a dime, you can suffer catastrophic losses. This is high-risk.
Credit card debt is accumulated charges – not paying off your full balance each month. Credit card debt is the worst type of debt you can get into (short of borrowing from the mafia, I suspect) because it can easily spiral out of control.
Rent (interest) is charged on your unpaid balance. Credit card debt has no pledged assets that can be repossessed; it is high risk for the lender. Interest rates of 15-20% are common.
If you are concerned about credit card debt, categorize your purchases over the last six months. Were they depreciating assets like televisions, phones or computer gadgets? How many were impulse purchases?
Next up is non-assets. How many meals have you charged because you didn’t have the money to pay for them? You may have tipped the server 18%, but the credit card company is likely charging 18% interest (or more) on top of the meal. If you think your daily Starbucks coffee is expensive, try charging it and adding to your outstanding balance.
How about charging an exotic vacation or expensive concert tickets? Maybe a gym membership while you are at it? It’s easy to have your cell phone bill, auto insurance and other recurring monthly expenses charged directly to your credit card. Many don’t realize how expensive “charge it” is when you can’t pay off the balance each month.
There is also a category I call “necessary”. When my oldest son was an infant, one foot pointed north and the other east. He needed special shoes every three months that would, over time, correct his feet/legs & stature so he could walk properly. There are times you do what you must – and that was one of them.
Credit cards do have one major benefit. At this point in life, my wife and I charge everything we possibly can. We pay them off each month and collect nice cash back rewards. We normally redeem them at year-end to help offset holiday gift-giving.
Some suggest they are just giving us some of our money back. Go to Walmart and ask if they will give you a discount if you pay cash. What’s not to like about free money for paying your bills on time?
If you feel like you are on the debt treadmill, how do you get off?
Wikipedia tells us about the “Law of Holes”:
“the law of holes is an adage which states that “if you find yourself in a hole, stop digging”. Digging a hole makes it deeper and therefore harder to get back out, which is used as a metaphor – that when in an untenable position, it is best to stop carrying on and exacerbating the situation.”
The best way to start – STOP accumulating more debt. There is a difference between needs and wants. Change your behavior, put the shovel down, and stop digging. Frivolous use of credit cards is nothing more than a huge debt shovel!
In today’s, “immediate gratification” society, it’s a tough realization that you can’t afford everything you want right now. If you want to increase your net worth, minimize the rent you pay for OPM and increase your assets that appreciate – adding to your wealth – not detracting from it.
It’s a challenge and both spouses must work together or the plan won’t work!
If you don’t have the ability to immediately pay off some of the credit cards, that’s OK. Target your spending habits. Reduce your total balance every month, or you are digging in deeper. One thing you have control of is your spending – that is where you must start.
Accelerate your payments where you can. Many experts recommend paying off high-interest rate debt first. The less rent you pay for OPM, the more you get to keep.
| The “theory” only works when you cut up the credit card and don’t go buy something else. |
The best way to understand debt
In my late 30’s I was diagnosed with hypoglycemia. My blood sugar levels were wacky, causing mood and energy level changes. The doctor put me on a strict diet. A month later I said, “I feel like a guy who had a headache his entire life and never knew it until it went away!”
This probably sounds corny but I never understood how physically, financially and emotionally painful debt was until it went away.
- You never learn how to manage money until you don’t have any.
- You can change your spending behavior.
- The best way to understand debt is to make it go away!
Once the debt goes away, you never want it to come back – EVER!
And Finally…
“If you always protect your offspring in a cocoon they will never learn how to fly…”
For more information, check out my website or follow me on FaceBook.
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Until next time…
Dennis
www.MillerOnTheMoney.com
A very worthwhile article. When I was just starting out with a young family I worked as an entry level pilot. (I paid for the training…cash; while I worked construction. I was 18 when I started flying bush planes). The job was Union, the wages were okay, but probably just 2/3 of what every other blue collar guy was making who lived in my neigbourhood. A result of that is that we never had debt in our family beyond a mortgage. Ever. Years later when I retrained, reschooled, and reset for a better salary and working conditions the same mindset continued. I retired in my mid-fifties, as did my wife. I am now building a rental home out of my deferred income. No debt. If we wanted to travel we would. Why would we? We love where we live and enjoy our lifestyle. My wife aslready did her globe wandering in her 20s. I spent enough time away flying in the north in my youth.
No debt = freedom, pure and simple. Debt puts you under the thumb of your creditors. Being free from debt allows one to never really think about money beyond common sense habits. Stuff does not make you happy and being in debt for stuff pretty much guarantees misery.
regards
Snowball. Pay off the lowest balance first. This gives the debtor a quick shot of accomplishment since its paid off quicker than a larger balance. Once that is paid, apply the payment to the next highest balance. It’s addicting. It worked very well for me.
I’ve given out this advice to every youngish person I know (so far, no takers): live beneath your means. I bought my last car new in 2005 and doubled up payments for two years to pay it off early. It felt so good to have no car payment that I started paying down my mortgage, and the monthly satisfaction of seeing the huge reduction in months remaining was like a drug spurring me on. After I paid the mortgage off, I spent another $600 at at title insurance company to prove I actually owned it. The freedom that comes from having no debt is fantastic.
For someone that finances the difference between their income and the cost of their lifestyle with debt, particularly credit card debt, it can be a surprisingly difficult and lengthy process to pay that debt off.
Best thing to do once you’ve decided to get rid of debt is to look at what you are spending your income on and start deciding what you can do without because you don’t really need it. Take a more utilitarian approach to your lifestyle, if you don’t need it don’t have it.
Debt is a millstone to be sure, but it also a tool. In addition, we are at a moment in history when debt and its use requires entirely new thinking. Like Dennis, we use credit cards for everything we can. We pay off the balance every month, so we pay zero interest and get 2-5% cash back on all these purchases. We also utilize 0% interest loans (right now we one on appliances and a water system)…these are dangerous, but can be used to one’s advantage. We could pay cash up front, but why? Cash on hand gives flexibility and security, that is not provided by owning appliances outright. Yes, these loans are beyond stupid and could never exist in a free market with sound currency, but we don’t have that type of system do we? Best to take advantage of what we do have. We all know this debt bubble must break sooner or later. When it does, it can go only one of two ways…deflation or hyperinflation. If the former, people call in debt, but will be willing to take less than full value, because the vast majority will be unable to pay anything. In that case, we pay less than we owe with the cash on hand (I am speaking on cash in the bank, here…if that is unavailable, then we and everyone else will have MUCH bigger problems). If the system goes the hyperinflation route, we simply pay off the loans with devalued money. Win.
Now, in the event that the entire banking system crumbles and then the whole complex infrastructure that allows our complex system to run, well like I said, we all have much bigger problems than debt. This is the Prepper wet dream that will rapidly become a nightmare in reality. I don’t want it, but am fairly well prepared for it.
Debt is bad, sure, but we are in extraordinary times. Hedge at a lot of different levels and be prepared to act down a lot of different avenues. And, meanwhile, stop and smell the roses from time to time.
Been out of debt for more than 20 years, retired for 18, and can live just fine on relatively low income from a pension, SS and savings. When we got married 53 years ago, I handed my wife my first paycheck and told her, “I don’t care what you do with the money as long as nobody ever comes knocking on my door to say we owe them money. In those 53 years, early on, my wife bounced one check because she didn’t know she had to deduct bank fees from the balance, and NOBODY ever came knocking on my door to say we owed them money. She paid everything on time.
Debt free also means you don’t need to be under the thumb of a boss ( which is usually worse stress-wise than debt ). I can now work for myself and not be concerned with low pay. Of course, I also refuse to own a car ( stay out of debt from going to the hospital by walking or biking instead of driving ) and built my own home on cheap off-grid land. Living on only a few thousand a year has costs of its own but Boss Free/Debt Free is well worth it.
You need to write an article detailing how you did it…are doing it.
I’ll post it.
Paulo ,hate the break it to you but you are NEVER out of debt.Even if you own a house you will be paying property taxes forever and ever .If you don’t the state takes your house.You ” own ” nothing . All this debt is created out of thin air and the loaner of this ” debt ” charges you interest on this Worthless paper. It’s the biggest fraud ,scam known to mankind when you consider all Banks( this includes your local community banks )are just counterfeiting machines.
Very true. Property taxes are probably the most unethical tax of all. In our county they use overhead photos to figure out whose been building on their property. If you use your after-tax hard earned dollars to buy some building materials (and pay sales tax on those materials) and then build a shop or a shed on your property with your own skill and effort, they will take a picture of it from the air and automatically raise your property taxes in the next year.
I think the Lord for the Burning Platform and the people who comment ( this includes you Stucky ).It is here that learned the truth about ” money ” ” debt ” and ” interest on debt “
Concise, easy read. Should be mandatory for HS grads to understand it before commencement ( a new beginning).
I do believe a 5th form of debt should have been mentioned. Student loan debt.
Not applicable if Daddy pays the note.
I know of one ditz in hock up to her eyeballs with that, and currently, SLD cannot be walked away from by filing bankruptcy. Stupid gal took world travel vacations, then their costs, and piled those debts on top of her student loan. Buried in debt, with no way out. What good is a degree if one has to devote 20 years of earning income % to service the debt hole. Then, “why can’t I get ahead?” is the whine, while drinking another $25 bottle of red. Insane.
We call those type of women “fiscally unattractive.”
As a debt free person, I will never ever understand how payday loan centers can be allowed to legally exist. Good God, they charge upwards of 450% interest. There are many more of these PLCs than McDonalds restaurants. What every happened to usury laws…? Pathetic.
“The best way to understand debt is to make it go away!
Once the debt goes away, you never want it to come back – EVER!”
Preach it brother! Even if it takes ten years of relentlessly putting every spare penny towards debt just do it! My ONLY regret is not doing it sooner. Being debt free is a whole new level of freedom. I’ve been suddenly panicked a couple of times since Sept thinking I had forgotten to pay the mortgage that month. That initial rush of adrenaline sucks but I hope it keeps happening for the rest of my debt free life!
If a car cannot paid for you need to think how will I beable to pay on it next year and so on never buy a house on anything but a 15 yr note. never go on vacation unless paid for me vacation are dumb thats what a backyard is for. I never got to go to college but I have 3 over the road trucks 20 rentals did have 25 sold 5. Worked hard and read many a book.
Yup.
I had friends that bragged they were going to retire long before I did.
She was a financial planner and told me to borrow on margin and cash in to make 30+% profit during the dot com bubble.
We declined her offer to help “guide” us use OPM to become wealthy.
We stuck with the boring stuff and continued to use our own money to slowly pay off debt to become debt free, then look for ways to keep more of our money and watch that grow.
They lost everything including their home and her job, and like the intelligent people they are, moved to Illinois and are now once again stuck in a high tax state with a home they can’t sell without taking another huge loss because no one wants to move to that state.
Basically slaves to their debt.
So if/when the bond market bursts, the market crashes, the dollar keeps falling, interest rates keep rising, national debt continues to climb, inflation resembles the 80’s again, debt free or as close as you can get to it is the best place to be.
We can’t control what might happen in the future, only guess by staying informed, but we can still prepare. No one will be pain free for sure, but not being shackled with paying off debt you can’t pay is still better.
Good letter Dennis.