When to use Debt
The best advise anyone can give regarding debt is to not be in debt or at least use it to your advantage. Have you ever heard the phrase “Credit is King”? Nope. How about the phrase “Cash is King”? Yep! That’s because ultimately it’s true.
Do you like going to your mailbox every month and getting another statement that says you owe money… with interest? Or would it be a tad more enjoyable for you to collect your mail and actually be getting money… with interest? Wow, what a concept!
The basic principles of finance boil down to assets and liabilities.
Debt as a Liability
Your consumer debt (credit card) is typically a liability that drags down your total assets. Let’s explore. Have you ever bought something at a store and paid for it by going into debt? Then while you are paying that item off you pay interest on that debt. When it’s all said and done you may have paid up to 4x’s for that item. The interesting thing is that as soon as you bought that item it most likely went down in value. Let’s follow the trajectory of that item a bit further. You’ve had the item for a while and you don’t want it anymore so you have a garage sale and sell it for 95% off what the store charged you. Here’s an example of what that looks like:
$50 The amount you paid for an item at the store
$60 – $200 The amount you paid to pay off the debt with interest
$2.50 The price you sell it at a garage sale
95 – 99% The amount of money you lost by using debt to buy the item
So when it’s all said and done you lost a lot of money. I sure hope that item was really cool. Now, if you’ve ever had to work for your money you may look at this and say that doesn’t make any sense and you’re right. Now, What are you going to do about it? I’m not saying that using debt to pay for something is bad… just pay it off as soon as possible. There are actually benefits to using credit cards to pay for everyday items. (link to future article)
Debt as an Asset
It’s not to say that there aren’t times where it may make sense to use debt as a sensible tool of leverage. The challenge lies when there is no clear distinction between “sensible” and not. Let’s look at a possible scenario where it may make sense to use debt. Imagine you are going to start a business. In order to get started you need $100,000 and you don’t have cash. However you have a great business idea and a plan to make it a success. If you have to get a loan the idea is to make that money make money as soon as possible. Here’s an example of what that may look like:
$100,000 The loan amount to start your business
$4,000 Gross profit from business after 6 months
$2,000 The monthly payments required too service the debt
= $2,000 Net profit – You have made debt make money for you… Yeah!!!
Let’s say it takes 6 months to start making $4,000 a month. That means you had to pay $2,000 x 6 months ($12,000) to keep the business going before profiting. After 6 months that debt is actually making you money. What a concept! I know this is an example that makes it look easy to have debt working for you. There is a lot of calculated thought into running a business and making that debt into money isn’t as easy as it may appear but the concept is strong.
The point of this conversation is too stop before going into debt and really examine why you are going into debt and what the consequences are going to be whether positive or negative. We are living in interesting times and we all need to be smarter about our debt.