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 debt goes away, you never want it to come back – EVER!
Note: I’ve recently released my newest report, “10 Things You Need To Know, That Brokers Won’t Tell You About Dividend Paying Stocks!“. It’s free for qualified retirement investors. Click here to claim your copy today.