The right angle on debt

The right angle on debt

Recently, I had the opportunity to speak to a group of entrepreneurs who are participating in a business accelerator program to learn the ins-and-outs of starting and running a business. During the session, I was asked to expand on a statement in their course material: most businesses must take on debt at some point. At the time, I was put on the spot and my answer wasn’t as articulate or clear as I would have liked.

Now that I’ve had a chance to think about it, I don’t agree with that statement at all. While it may be true that most businesses do take on debt at some point, I disagree with the idea that most businesses must take on debt at any point.

Strangely, I think I was the only one there — instructors included — who disagreed with the notion that most companies need debt.

Debt has become so prevalent in business, government, and our personal lives, that we’ve become numb to it. We’ve been told so loudly and so often that debt is the answer to all of our problems that we’re starting to believe it.

How could you buy a house without a mortgage? How could you start a business without visiting the bank for a loan? How could you afford a new iPhone without a payment plan? How could you survive an emergency without a credit card?

Not only how could you, but why would you? Isn’t debt a tool? Successful businessmen know the secret to amassing great wealth is using “other people’s money,” right?

And now, with interest rates so low, it’s almost a crime not to borrow.

As a result, we’ve accumulated a national debt of an incomprehensible $27 TRILLION. Businesses are borrowing money for sport. They’re not borrowing to buy property or equipment or to invest in their business to produce a return, but to pay dividends to shareholders or buy back stock. It’s unproductive debt. But why not? With interest rates this low, wouldn’t it be irresponsible not to?

We, as individuals, finance almost every purchase we make. Leases, no payments for 12 months, 6 months same as cash, just 3 easy payments — debt, debt, debt, and debt. Even a pack of gum is charged to our credit card — debt for a $1.50 purchase!

Ah, but credit cards are smart debt, another tool of the wealthy. It’s free money, really. We earn cash back or points on purchases we were going to make anyway, and as long as we pay the balance in full every month, we never pay interest. Not only do we not pay interest, but we can earn interest on the float. Essentially, Visa is paying us to use its card.

Allow me to let you in on a little secret: Visa doesn’t earn $12 billion in profits every year by paying its customers to use its credit cards.

I think that gets to the crux of the issue with debt: businesses are experts at convincing us it’s in our best interest to give them our money.

In Never Split the Difference, Chris Voss defines negotiation as the art of letting someone else have your way.

Businesses are unbelievably good at making us feel like we’re getting the better deal. They’re so good in fact that they not only convince us that a product or service is worth buying, but that it’s so valuable, it’s worth taking on debt and ultimately paying more so we can have it now.

Don’t feel bad if you’ve fallen victim. I have, too. Our instant gratification, consumer society was engineered to make us desire more than we can afford. As far back as 1927, Paul Mazur, a Wall Street banker at Lehman Brothers, said:

“We must shift America from a needs- to a desires-culture. People must be trained to desire, to want new things, even before the old have been entirely consumed. … Man’s desires must overshadow his needs.”

In our zeal to have more right now, we’ve allowed businesses to shape the conversation about debt and failed to truly understand debt or count its cost.

Literal cost of debt: interest

What is the first question a car salesman asks when you walk into his show room? How much are you looking to spend per month?

Don’t answer that question!

I know it’s tempting to think about affordability in terms of monthly payments, but that’s the wrong question.

Would you rather pay $249.02 or $283.07 per month for a $15,000 car? You may be tempted to “save” $34/month, but let’s take a closer look at the options:

Option A — $249.02/month

  • Term: 84 months (7 years)
  • Interest rate: 10%
  • Total payments: $20,917.68
  • Interest paid: $5,917.68

Option B — $283.07/month

  • Term: 60 months (5 years)
  • Interest rate: 5%
  • Total payments: $16,984.20
  • Interest paid: $1,984.20

Same car, same retail price, but if you chose the cheaper per month price, it would cost you almost $4,000 more and 2 additional years to fully purchase and own the car. You will finally own your car just in time to need a new one and do it all over again.

Even if you chose option B, almost $2,000 in interest means you end up paying 13% more for the car than if you chose neither financing option and paid cash up-front.

The dealer makes money if you pay the retail price of $15,000 cash today. So, why do they push a lease or loan? To make even more money, of course! And ironically, by switching the conversation to the more profitable monthly payment options instead of purchase price, they are also more likely to make the sale.

I can’t afford $15,000! Are you out of your mind? But less than $250/month — I can see myself driving home in this car today for that price.

I can’t afford $15,000; I’d much rather pay $17,000 or, better yet, $21,000. That’s essentially what we’re saying.

The point is you can end up with a really bad deal if your only criteria is monthly price. The purchase price and terms of the loan are far more important before you even consider whether you can afford the monthly payment. Understand your total cost when you consider buying something with a credit card or payment plan or even a traditional loan.

Don’t make a bad deal because you can afford the monthly payment. That’s how you end up digging yourself into a hole you can’t get out of.

Hidden cost of debt: risk

Even if you accept the fact that you’re paying more (a lot more) over time, there’s another cost to debt: risk.

Debt is a promise to pay in the future. The monthly debt payment is a fixed cost, meaning you have to pay every month no matter how much money you earn that month. You get money you don’t have to purchase something you want right now, but in exchange, you agree to give up future money.

The reality is we’re not using other people’s money; we’re giving other people first dibs on our future money.

Signing away your future earnings is a very real risk. What if you lose your job or have an expensive emergency? Isn’t that question especially appropriate as we live through a pandemic, forced shutdowns of businesses, and mass layoffs? You have to make your debt payments before you even feed your family. If not, you either end up allowing interest to accumulate, digging yourself into an even deeper hole, or the bank takes its asset back — your house, car, phone, or whatever you put up as collateral. That’s when you realize you never really owned what you financed in the first place— the bank did — and after all those monthly payments you made, you have nothing to show for it.

So, can you afford the risk? Risk boils down to the probability that you won’t be able to make the agreed upon payment. If your debt payment is $1,000/month and you typically earn $2,000/month, your debt is risky because the monthly payment is half of your total pay. If instead you typically earn $10,000/month, your debt payment is less risky because you have more margin (cushion) — ie. you can have a bad month of income or unexpected expenses and still make your debt payment.

While risk is minimized the smaller the payment is relative to your income, the question becomes: if your income can easily cover the debt payment with minimal risk, why are you taking on debt in the first place? Just save, purchase with cash, avoid paying interest, and have zero risk.

Is all debt bad?

Given the costs, you may assume my answer would be yes, all debt is bad, but that’s not the case. Debt can be reasonable when it is secured by an asset likely to retain its value, with a low loan-to-value and/or a high likelihood to produce income that will cover the debt payment.

Assets likely to retain value are physical property in limited supply, such as a home or building, land, and some large business equipment. Cars do not qualify.

Secured means the asset you purchased serves as the collateral for the loan. If all goes bad, the bank takes the asset as payment for your loan obligation. While you don’t want that outcome, it’s far better than an unsecured loan, in which you are the collateral. An unsecured loan is guaranteed by you — all of your assets and future income. If you can’t make the payment, the bank goes after everything and can even garnish (take) a portion of your future paychecks until their debt (plus interest) is paid in full. Credit cards, student loans, and many business loans are examples of unsecured loans.

Low loan-to-value means the loan is relatively small compared to the value of the asset. This typically means you’ll put at least 20% or more in cash as a down payment and finance 80% or less of the asset purchase. The reason you want a low loan-to-value is if you find yourself in a position where you can’t make the monthly payment, you can most likely sell the asset (because it’s likely to retain its value, right?) for at least the amount of the loan outstanding and pay the debt off.

In the best-case scenario, the asset not only is likely to retain its value and you finance with a low loan-to-value, but the asset produces more than enough income to cover the monthly debt service. For example, a residential rental property may be likely to have tenants whose monthly rent covers the debt payment.

So, what is the proper amount of debt?

I once heard that the proper amount of debt is whatever amount of debt you can have and still sleep at night. The proper amount varies by person because risk tolerance varies by person.

My opinion is that no debt is the proper amount of debt. Zero. Zilch. Nada. Debt-free is the only way to be.

Even the “reasonable” debt mentioned above comes with a claim on your future income, risk, and costs significantly more over the life of the loan. Of course, you’ll hear everyone shouting from the rooftops that you’d be crazy not to take advantage of today’s historically low interest rates. Well, count me crazy.

As a side note, do you notice how home prices typically rise as interest rates fall? Why is that? Perhaps we’re again more concerned with the affordability of the monthly mortgage payment than the price we’re paying for the home. In that case, do we save anything by taking advantage of these incredibly low interest rates but paying significantly more for the home? What happens as interest rates rise over the course of your 30-year mortgage? They have nowhere to go but up from here. Will home prices fall or at least not rise at the same pace as interest rates? What does that mean for the value of your investment?

Just like our discussion about car loans, interest rate and monthly payment shouldn’t be your exclusive factors in deciding to buy a home. Or you could always pay cash and eliminate interest rate from the equation entirely.

But it’s just not possible to live debt-free.

I couldn’t disagree more. It’s not only possible, I would argue it’s preferable.

Trust me, I’ve been there. I had credit cards for emergencies and for the rewards. I’ve leased vehicles and business equipment. I purchased phones on payment plans. But then I took a hard look at my budget and noticed how much of my next paycheck was already spoken for. I was working hard, yet had nothing to show for it because most of my pay was going out as fast as it was coming in. I realized I had bought into a lie and there was no way I was going to get ahead living like this. Then, I started imagining what it would be like to be debt-free, how that would change my budget, how much more of my paycheck I would get to keep and how much less I would have to worry about being able to make payments.

Debt-free means living within your means. It means spending less than you earn. It means minimizing risk. It means resisting the cultural pressure for more, now and, instead, seeking financial sanity, contentment, and peace. Ultimately, debt-free means choosing freedom over stuff.

Happy is he who owes nothing.

You may not be able to have everything you want, but what you do have, you own, you appreciate, and you understand and accept the cost.

Even if you’re like most Americans, drowning in debt, the path to being debt-free is not complicated. It’s about a change in mentality, breaking the cycle of debt, and developing and committing to a plan for your money. We’ll outline the debt-free plan in more detail in future articles, but the first step is to understand debt, its costs, and why there is so much pressure to take on debt in our society.

Understand that debt is everywhere, not just in the form of loans for large purchases like cars and houses. Every time you get something now by committing to pay later, you are taking on debt. Every time the cost is shown as a monthly payment, that’s debt.

Most of that debt is unsecured, meaning you’re on the hook no mater what — all of your assets and future income — until that debt is paid in full, including interest.

All of those “free” credit card rewards are paid for by you. You didn’t find a way to game the system. Even if you’re paying your balance in full every month, Visa earns money every time you swipe your card, in the form of interchange and merchant fees. The better the rewards on your card, the more the merchant has to pay in fees to process your transaction. And the higher the merchant’s costs, the higher the prices of the items you just bought. Every time you get more perks or rewards for using your credit card, the price of everything you buy with that card increases, too.

In addition, if you’re unable to pay the balance in full for just one month, the interest on credit card balances is incredibly high, and those rewards will be eaten up by interest in a very short time.

Finally, having a credit card for emergencies is like having gas to put out a fire.

The message that debt is necessary or even beneficial is a lie to get you to buy more. The rich don’t borrow; they lend. By definition, those with significant debt are not rich. Wealth or net worth is assets (what you own) minus liabilities (what you owe — debt). Therefore, the only way to wealth is by increasing assets and decreasing debt.

The truly wealthy people I know pay cash for everything, use debit cards instead of credit cards, and if they don’t have enough money to buy something they want, they just say no (for now). And “wealthy” does not necessarily mean multi-millionaire. It means their assets significantly exceed their liabilities. Your neighbor could be the wealthiest person you know, and in fact, he is much more likely to be wealthy than the guy down the street with the fancy car, designer clothes, and vacation home — all purchased with debt.

Warren Buffett, one of the greatest investors of all time and richest people in the world, currently owns an interest in all three major credit card companies — Visa, MasterCard, and American Express. Yet he pays cash for everything and doesn’t even carry credit cards. Why would anyone own a company but not use its products himself?

Of course, people will say the rich can afford to pay cash for everything because they’re wealthy. I would argue the opposite: they are wealthy because they refused to take on debt and instead, paid cash for everything.

There are no shortcuts to success or wealth. The only sure path is diligence plus time. Debt is not a shortcut to anything but regret.

Every dollar you borrow today costs you significantly more than a dollar tomorrow.

Every dollar you save today earns you significantly more than a dollar tomorrow.

It’s really that simple. You have to enjoy saving more than you enjoy spending. You have to prioritize your future instead of allowing others to use your money to prioritize theirs.

Owe no one anything, except to love each other, for the one who loves another has fulfilled the law. — Romans 13:8

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