Tuesday, June 26, 2012

OPM - Other People's Money and Why It Doesn't Apply to You....

Many consumers banter about financial terms like "Opportunity Cost" without knowing what they mean.  The phrase "Other People's Money" is another phrase that likely doesn't apply to you.

In my posting Opportunity Cost, I pointed out how that phrase (and concept) has no application to the average consumer.  People like to think they sound smart when they say, "Well, I could have paid cash for this car, but what with the opportunity cost and all, it was better to finance."

It is an argument that makes no sense, as the guaranteed savings of not paying 5% or more interest is far greater than what you would get on a CD in the bank - and those are the comparable "investments", not stocks or some other speculative investment.

Opportunity Cost really only makes sense for businesses - where for them, borrowing money means freeing up more capital to pursue a business project that will generate income for them.  Buying cars and other consumer goods, on the other hand, is just spending money and there is no "opportunity" that you are taking advantage of by financing a car, other than an opportunity lost.

As one helpful reader noted, when you spend $25,000 on a brand new car, and then pay interest financing it (and please, don't tell me about "0% financing" - you really aren't that stupid are you?  The 0% financing gag means you forgo a $2000 rebate - there's your interest right there) the real opportunity you are losing is the chance to invest $27,000 and get some rate of return, and keep your old clunker in the driveway.

Not Spending provides the opportunity.  Spending and financing is not creating opportunity.  But car salesmen (and all salesmen) will throw out phrases like "opportunity cost" to confuse you and to get you to think that an odious new car purchase and loan agreement is not a stupid idea, but in fact a smart one.  It is not.

The same is true with the phrase "Other People's Money" - which was bandied about a lot in the late 1990's and early 2000's, as we all, well, spent other people's money.

The phrase is similar to opportunity cost and makes sense in a business context only.  The complete phrase was something along the lines of, "Always use other peoples money, instead of your own!" and what this meant was, when you are starting or running a business, you can leverage yourself and hedge risk by borrowing money ("OPM") and thus risk less of your own capital.

For example, you start a restaurant.  You borrow money from investors or a bank to pay for renovations and start-up expenses, and to cover the overhead for the first few months (to a year) until the business is solvent and profitable.   If you are successful, you pay back the investors their money, plus interest.  If you are not, you declare bankruptcy, walk away, and leave the lenders holding the short end of the stick.

Since it is a business bankruptcy, and not a personal one, you lose little in the aftermath, unless you did something really stupid like personally guaranteeing the notes.

For a businessman, who does not have emotional panic when the word "bankruptcy" is bandied about, this makes sense.  And it is how businesses work and how business is conducted.  And lenders know this, which is why interest rates on business loans are so high.

But OPM doesn't make any sense for you, as a consumer buying consumer goods or a personal residence with OPM.   All you are doing is borrowing and paying back, with interest, and there is little or no chance of making a "profit" on a Jet Ski or even your personal home.  As I noted, over time, you get back what you pay in to your personal residence, with the cost of insurance, taxes, repairs, and interest.  This is not to say that buying a home is a bad deal - far from it.   But the reason why home sales are tax-free is mostly because you really aren't making money on your home (But you do get that money back, at least).

On the other hand, if you can buy an investment property using borrowed money, and then pay back the loan from the rental proceeds and leave yourself a hundred bucks at the end of the month, you can use "OPM" to leverage a business proposition that you could not otherwise pay cash for.   Over time, as rents increase, you will make more and more money, and eventually, you pay off the loan and own the property free and clear, without having paid a nickel of your own money for it (and yes, I did this).   And presumably, it has appreciated in value by then.  You can make a lot of money this way, but of course it requires that you own and know how to use, a calculator.

So why do people in the cul-de-sac of Foreclosure Mews Estates all like to banter about terms like "Opportunity Cost" and "OPM" and the weekly cocktail parties and Barbecues?   Well, for starters, it is a way of trying to look sophisticated and worldly, and financially astute.   But moreover, it is a way that the suburban middle-class poor reinforce each other's normative cues.   Joe and Suzie homeowner might feel rightfully nervous about doing a cash-out re-fi on their split level, so they can pay off their credit cards.  But when their neighbor, after a few drinks, makes a joke about "OPM" they feel better - and even feel they have made a smart move and are now part of the smart set.   Hey, maybe now they can buy that Acura like their neighbor has, using their home equity line of credit.

But no, it is not a "smart" idea.   Using Other People's Money to just buy rapidly depreciating consumer goods is never a good idea.   And using the OPM mentality to bootstrap bad decisions is even worse.