Tuesday, October 5, 2010

Debit versus Credit

Many Economists argue that borrowing money is a good thing and helps stimulate the economy.  What they don't explain is that they are talking about borrowing for business and industry, not on a personal level.  Although some Economists argue that borrowing on a personal level is also a good thing.  Is it?

In my small business, I have to pay fees to the Patent Office on behalf of clients.  There are three basic ways to go about this.  First, I can put the fee on a credit card, then invoice the client, and hope the client pays me before the credit card bill comes due (they rarely do).  Second, I can pay the fee from my deposit account using money on hand, and then invoice the client and hope the client pays me before too long (they rarely do).  Third, I can get the money from the client in advance, and then pay the fee, which obviously is the best way to proceed.

With the changes in the economy and the practice of Patent Law, I am moving to the third model rather than the first two.  Traditionally, Attorneys, like department stores, would let clients ring up a bill and then let them pay later.  Sometimes it works, other times, when the client goes bust, it goes horribly wrong in a bad way.  And recently this happened to me in a bad way, to the tune of $7000 in PCT fees which I had to cover out of pocket.  So no more paying fees on behalf of clients and borrowing the money to do it!

But getting back to the first two options, is it better to BORROW money and use it, or to take money out of SAVINGS and use it?  Some Economists argue that borrowing is a good thing, and in fact an engine of the economy.  We can control behavior of people by controlling interest rates, thus encouraging or discouraging borrowing.

As we speak, Economists are discussing ways of tweaking interest rates and inflation to stimulate the economy.  They want people to spend more to get the economy going - even if it means borrowing money.

But while that is all very well and fine for an economic model, how does this affect you personally?  If I borrow $1000 on a credit card to pay a client fee (or to do anything in my personal life) then I have to pay that back - with interest.  At, say, 10% interest, which is not unusual for a credit card these days, this could be as much as $100 in a year or perhaps $10 in one month.

On the other hand, I could take $1000 out of a savings account and pay the fee while waiting to be reimbursed.  I would pay nothing in interest, and owe no one, and moreover not risk ending up with a large debt that has to be paid off over time (which could add a lot to the interest payments!).

Now, an Economist would argue that I am missing out on the "opportunity cost" by tying up all that capital - interest I could be earning on it.  Economists are assholes, sometimes.  You see, while that may be true for a corporation with one million bucks invested in high-yield securities, for you and me, on a personal level, we aren't going to get much "opportunity" for our $1000 in a few months.

Right now, banks are paying maybe 1% interest - if that - on savings.  So if I keep that money in the bank and then borrow on my credit card, I am hardly missing any opportunities.  And even in other times, where banks are paying other interest rates, the same effect applies.

Banks lend out money at higher interest rates than they pay to customers.  Generally, there is a spread of at least 5-10% that they take as their "taste".  So what they pay you is a pittance compared to what Joe's Construction company pays them for the loan on their new bulldozer.

Yea, you could loan money directly to Joe and make out, but chances are, you don't have the $50,000 that he needs to buy a used bulldozer.  Moreover, chances are, you don't want the risk that he will go belly-up or the inconvenience of having your money tied up for five years in a bulldozer loan.  So you deposit it to a bank, and they take the risks and tie up the money and earn a profit.  You have the convenience of being able to deposit smaller amounts and withdraw them at will.

For the small investor - middle-class schmucks like you and me, there is little or no "opportunity cost" in tying up capital this way.  So shame on those economists who even raise the issue for individual finances.

Having money in the bank and spending only what you have, on the other hand, yields substantial return on your "investment".  If you borrow $1000 on your credit card, you have to pay 10% or so in interest.  If you pay cash for the same transaction, you are, in effect, getting a discount equal to the interest you would have paid on that card.

So being debt-free is a good thing.  If you have a perpetual balance on your credit cards (which most of us do, despite what we claim) then you are poorer every month by the amount of interest you pay.  For many people, this can be as much as $1200 to $2500 a year - or more.  That is a lot of dough to be coughing up, year after year, just to have "things".

But what about your mortgage?  On a $250,000 mortgage at a paltry 5% interest rate, you'll pay nearly another $250,000 over the life of the loan in interest.

Now suppose you paid CASH for your home instead?  Well, you'd save that $250,000 in interest, that much is clear.  But what about the fabled opportunity cost?  Well, assuming you could get 5% return on the money, that $250,000 invested would equal over a million bucks.  Wow!  Those economists were right!

Oh, but wait.  Go down to the bank and ask them for a CD at 5%.  When they get done laughing, they will throw you out of the bank.  Yea, sure, you *might* get a great return in the stock market.  But now you are comparing apples (a 100% risk-free investment like a paid-for house) to oranges (speculative stock investments that can drop to ZERO overnight).

At most, the bank might offer you 2% on an FDIC insured deposit, and guess what?  That works out to about $250,000 in interest after 30 years.  You might be able to put the money into a longer term instrument and get higher interest, but of course, then your money is tied up and difficult to liquidate - apples and oranges again.  A house can be sold, usually within a year, if you decide you need the money later on.

And note, just as before, the actual interest rate numbers don't matter.  If rates go up for savings, they will be proportionally higher for mortgages - which means that you end up in the same spot - where interest paid on a mortgage is about equal to what you'd earn in savings over the same 30 years.

So as a core, safe, "paid for" investment that can be fairly rapidly liquidated, a "paid for" house is not a bad idea.  But yet many economists and tax advisers would cringe at the thought.  After all, that's tax-deductible debt!  But debt by itself is not desirable, and tax-deductible debt is only slightly less desirable than the non-deductible type.  You cannot deduct your way to wealth and the IRS tax code is a crummy investment guide!

But wait, it gets better.  In our mortgage example, the monthly P&I was about $1250.  If you put that amount into savings over the 30 years you are NOT paying mortgage payments, and put it into a paltry 2.5% return account, you'd have $750,000 more at retirement, with little risk.  Want to get risky?  At 5% you'd have well over a million bucks.  So the "opportunity cost" in paying cash for things is not as great as it seems - as you will have all those monthly payments as investment opportunities down the road.  Economists fail to take into account the "opportunity cost" of $1250 a month for 30 years, invested in your 401(k).

Taking the opposite tack -  borrowing money for the home and investing the cash in stocks, you could end up losing it all in the stocks and end up "upside down" on the home - and have a hefty monthly minimum cash flow to feed.  You stop paying for a few months, and it all goes horribly wrong, very fast.  Sound improbable?  Maybe 5 years ago, I would have said "yes" - but today it is a common occurrence for a number of Americans.

But that is not the end of the analysis.  All of the above assume you can pay off your debts and don't get in "over your head" with credit card or other debts.  If you operate on a cash basis - spending only what you have - then you automatically budget yourself, as you cannot spend more than you have in your hand.

Credit cards, on the other hand, with their siren song of "buy now, pay later!" encourage over-consumption - living beyond your means.  There is the added danger with debt of taking on more than you can ever pay off and ending up in a very bad place in a very short period of time.

And many Americans are finding themselves in that very bad place right now - heavily in debt with no way out.

Easy money was the problem, not the cure.  Offering "liar's loans" and no-money-down mortgages with funny-money repayment terms only encouraged people to get upside-down in their homes.  Attractive re-financing to pay off credit card debt only meant that many Americans are now amortizing, over 30 years, a McMuffin sandwich they charged on their VISA five years ago.  Debt is not a good thing!

On a business level, debt can be good sometimes.  A company can buy machinery, expand to meet market demand, pay off the debt from profits and then grow - hiring more people.  But the difference between you and a corporation is that the corporation uses that money to enhance productivity - like a farmer borrowing "seed money" from the bank, the result is something worth more than you paid for it.

Personal debt, on the other hand, usually secures depreciating assets, like cars, or even meals charged to a credit card.  The only appreciating asset might be a home, but as recent events showed, there is no guarantee of that.

In the long run, you have to get out of debt - you have no choice about that.  Either by paying it off, or by declaring bankruptcy, or by just walking away from it.  You cannot go into retirement with a lot of debt, unless you have a boatload of money, too.  And if you had a boatload of money, well, you wouldn't be in debt, would you?

The only exception, I suppose, might be for the five remaining people in the US who have "defined pension benefits" - a monthly income for life - when they retire.  But even then, having debt when you are retired will mean a less enjoyable retirement, as you will have those monthly payments (and interest) eating away at your disposable income.  And just pray every night that your pension plan doesn't go bust and leave you with 40 cents on the dollar.

For the rest of us, retiring on our savings, debt is simply not an option.

And the sad thing is, many people in this country end up heavily in debt for consumer purchases - luxury houses, luxury cars, restaurant meals, and the like.   Unlike debt from a prolonged illness, such debts are totally preventable!

So cut up those credit cards - use debit cards instead.  And work out a plan to pay off your debts before you retire.  Debt-free is not some impossible dream, but has to be a reality, if you ever want to be truly free in our society.

Proverbs 22:7- The rich ruleth over the poor, and the borrower is servant to the lender.