Sunday, October 24, 2010

Why Debt is BAD! (The Priciple's the thing!)

Having a lot of debt is bad, no matter how low interest rates go, or whether interest is " tax deductible"  for the very simple reason that regardless of interest, you have to pay the principle back!

A lot of people like to use self-justification reasons to convince themselves that it is OK to have a lot of debt.   These reasons include:

     1.  Interest rates are at an all-time low!  Now is a great time to borrow!

     2.  Home mortgage and vacation home mortgage interest is tax deductible!

      3.  There is an "opportunity cost" to paying down debt or paying cash!

     4.   Everyone borrows money to buy things!

All of these are specious reasons and often employed by salesmen to "close the deal" on a car or motorhome (the latter being declarable as a vacation home, and thus the interest deductible).  But they are all basically false and poor reasoning.

The main problem with debt is that you have to pay it back.  Even if you could borrow $25,000 interest-free to buy a car, you are now committed to paying that $25,000 back, eventually.  So like the man in the picture above, you are burdened with debt.  You are far better off buying a less expensive lightly used car, 1-3 years old, and paying cash - about half to two-thirds the cost of a new car.  Even if interest was not an issue, you'd come out way ahead.

(and note that the "0%" interest gags used by the car dealers are really not interest-free.  You have to pay full retail on the car and forgo any rebates applicable to the car.  So you end up paying the same amount as you would through regular financing.  It is just a shell game to make it seem like there is no interest.  Oh yea, and when you get there, they will tell you that anything less than a credit score of 800 doesn't qualify.  It is just a gag - a con - and who buys from con men?)

But of course, interest is a big issue, adding 25-50% to the cost of any item purchased on credit.  But for many people, the principle alone is enough to sink them.  They cannot ever reasonably pay off the principle of a loan, and thus make interest payments monthly on a debt that never seems to go away.  This is how "revolving" credit works - an insidious debt that grows over time, like a cancer, until it reaches a point where the borrower can never pay it off  - even if it was interest-free.

So all of the rationalizations about debt above ignore the problem of the principle.  If you can't pay off the principle, then the interest is surely going to kill you.

But let's look at these excuses and deconstruct them one at a time:

1.  Interest rates are at an all-time low!  Now is a great time to borrow!  Interest rates are at an all time low - for banks.  But for your credit card, it may still be at 12-15% which is considered "good" by most Americans.  This is a lot of interest to pay and can double the cost of purchases.  Even lower interest mortgages can double the price of a house over 30 years, with interest payments.  And of course, if you want to "refi" to take advantage of these low rates, expect to add $5000 or more to the balance of your mortgage and reset the payoff to 30 years again. 

2.  Home mortgage and vacation home mortgage interest is tax deductible!  As we have discussed in this blog time and again, you can't deduct your way to wealth.  Even with tax deductions, you will still pay tons of money in interest - and still have to pay back the principle.  Paying too much for a house, or worse, a motorhome or boat (which can qualify as vacation homes), will leave you broke, even if they waived the interest.  And as we illustrated in a previous post, it is all too easy to be upside down in a boat or motorhome.  You cannot deduct your way to wealth, period.

3.  There is an "opportunity cost" to paying down debt or paying cash!  This is only true if the cash you are "tying up" by making a cash purchase or paying down debt could earn more money to you at the same risk level.  Yes, in theory, you could make 15% in high-risk, high-yield stock funds next year.  You could also lose all of your money this way.  But paying off debt or avoiding debt by paying cash for a purchase ends up saving you a guaranteed amount of money in the interest you aren't paying.  So the idea that you could invest and make more is great - in theory - but in reality it is comparing apples and oranges.  Moreover, "opportunity cost" is an economic theory more applicable to businesses, which uses their money to make money, not to buy depreciating assets like cars and jet skiis.

4.  Everyone borrows money to buy things!  No, not everyone, just poor people and the middle-class-poor.  If you want to be one of those poor saps who lives "paycheck to paycheck" on $100,000 a year, go right ahead.  Just put everything on credit.  It isn't hard to do.  But you will end up owing, not owning, as you will forever be paying for your purchases long after you have made them.  Give yourself a 10% raise and stop buying everything on credit!

* * * *

The credit industry likes to spread these myths, as it helps their industry.  The more people borrow, the better off they are, of course.  If people started going back to paying cash, they would suffer.  Moreover, if people had to pay cash for everything, they would scrutinize prices more thoroughly and think long and hard about purchases more.  Guess what?  That is what you are supposed to be doing, anyway!

Credit also allows merchants to obscure the price of things by concentrating on "monthly payment" and not overall cost.  Adam Smith's "invisible hand" of the marketplace is blind if it cannot see real pricing.  Transparency in any market is essential if it is going to be a fair market.  But once you can sell someone on "monthly payment" you can obscure pricing.  And as I noted in my Monster Motors posting, many new and used car dealers do just that - promote cars based on monthly payments.

Debt is bad, period.  Get out of the habit of thinking that it is OK, acceptable, economically preferable, or that "everyone does it" so it must be OK.  Watching TeeVee only serves to enforce these sort of myths, as that propaganda machine bangs them into your head.

Debt-free is really the only way to go - if you want to be free yourself.