Introduction to Debt

Debt. The word seems to conjure negative connotations, the ultimate evil when building a stable and promising personal financial future. In fact, nothing can be further from the case. Sort of. What do I mean?

Well, debt can be a valuable tool in personal finance, and often a vital one. Studies have shown that property ownership, which is most often financed by debt (specifically known as mortgages), has a wonderfully positive correlation with above-average wealth accumulation. Notwithstanding the recent economic events of the past few years, married couples who have committed to house ownership with the help of a mortgage, has on average, accumulated about 10 times the wealth as single, non-property owning individuals (upon retirement)! Experts have disagreed over the reason for this anomaly – but I believe the reason to be something about increased responsibility. Having a family, combined with a mortgage, will force families to save money by contributing a very significant part of their income into building equity into their house. Individuals with no house/mortgage, simply end up spending their extra income on perishable items, and find that, upon retirement, they wonder where all the money earned over their lifetime went!

On the other hand, debt can be a very dangerous investment (including mortgages!), and is often the undoing of many individuals and their personal financial situations. The key here is to exactly understand how debt works, and how to identify the good debt from bad debt. In this post, I’m going to give an overall introduction to exactly how debt works, and in subsequent posts, I will be discussing the various kinds of debt that is offered to the residential community, and how to approach them. So here goes.

What is debt? This may seem obvious – debt refers to money borrowed. Why would anyone want to lend out his/her money? Because money lent out produces a return on investment (ROI) – specifically interest payments. If I lend you $1,000, and receive $100 from you in interest every year, I am receiving a 10% return, or, said differently, charging a 10% interest rate on my money that you borrowed. Why would anyone want to borrow money? To produce a return on investment that otherwise would not have been attainable without the borrowed money. These investments can produce returns that do not necessarily have to be monetary; for instance, I may borrow money to finance a convertible, which brings me a return composed of pleasure, ego-pumping, etc. (point is, it's not a monetary return!).

What differentiates different types of debt? There are many factors, but by far the most important one is the interest rate, which refers to size of the annual interest payments relative to the size of the overall debt. Mortgages usually have low interest rates, while credit card balances usually have very high interest rates. Why would that be? It’s all about the risk of defaulting on the debt. If you had $1,000 to lend out to someone, and the first person who asks you for the money was a beggar off the street with no assets whatsoever, you’d probably ask for an extremely high interest rate on your $1,000, because the risk of a beggar blowing your money and then not being able to pay you back is really high. Conversely, if you lent your $1,000 to the US government, you’d expect a much lower interest rate, because the chances of the US government defaulting on its loans are essentially nil.

In reality, this is exactly how the real credit markets work. Mortgages, or secured lines of credit, often carry relatively low interest rates, because there’s a property/asset backing up the loan. The banks knows that if you default on your mortgage, it can (and will!) re-possess your house, sell it, and get back its money. Therefore, the risk of lending money to you is much lower (even for mortgages though, banks charge variously higher and lower interest rates based on the borrower's credit history, wealth, income etc., but these rates usually don't exceed 10%, because of the property collateralized against the money borrowed). On the other hand, credit cards carry high interest rates because they are unsecured borrowings. To become a credit card holder, all you have to do is fill in an application, and sometimes the bank will run a credit check on you. But the fact is, the bank has no guarantee on your loan, so it has to charge you higher interest rates. This is one of the biggest misconceptions about banks. Most people believe that banks are evil for charging incredibly high interest rates on their credit cards to unsuspecting borrowers. But the funny thing is, those rates are a reflection of the borrower, not the bank. The bank will be happy to lend you money at a cheaper interest rate, if you are able to prove that you are a credit-worthy borrower, or back your borrowed funds with some assets. If all you do is fill out a credit-card application, the bank has no choice but to charge you a high interest rate; otherwise, it will lose money in the long run. (Note – I never said banks aren’t evil – I just said they’re not evil for charging high rates on credit cards!).

So what should be the strategy for someone who needs to borrow money from a lending institution? You guessed it – try to obtain the lowest interest rate possible. The difference between a few interest rate points on a loan is absolutely humongous. For example, let’s say you want to take out a 25 year, $300,000 mortgage, compounded monthly. There are two companies offering to give you the mortgage. Bank A will lend it to you at a fixed interest rate of 5%, and Bank B at 7% (assuming that rate is fixed for all 25 years of the mortgage). Over the entire lifetime of the mortgage, how much more in interest payments will you pay if you took the mortgage from Bank B, rather than Bank A? Care to guess? The answer is (drum roll please): $109,735. Incredible! A 2% difference in the mortgage interest rate (5% vs. 7%) will result in over $100,000 in increased interest costs over the lifetime of the mortgage.

How can such a small interest rate difference equal such a huge overall interest payment difference?

The answer is surprisingly simple and very much related to some of the previous posts on this blog – regarding saving. Debt is essentially negative saving. For example, if you had $100,000 in savings and $100,000 in debt, overall, you have net $0 in savings. Savings minus debt equals wealth. Our goal is to increase wealth, and therefore there are 2 ways to do that: a) increase savings or b) decrease debt. So debt is nothing more than negative savings. When we talked about savings, the incredible power of compounding interest was described. Over time, interest on savings (let’s say, interest earned on investments in the bank) compound and grow exponentially. (See the 'intro to investments' post to fully understand this concept). Since debt is nothing more than negative savings, it works the exact opposite way. Interest on debt is exponentially increased as the debt interest rate grows higher. So while the goal on our savings accounts it to gain the maximum possible rate of return on our investments, the goal of our debt is to lower the debt interest rate, because it works in the exact opposite way of savings.

Said differently - if you had $10,000 in debt which charges you a 10% interest rate, and $10,000 in savings that grow at 10% each year - you essentially have $0 in savings, and you will always have $0 in savings for years to come. Both debt and savings grow at the exact same pace, so they will always cancel each other out. My point is - savings and debt are the same thing, just 2 sides of the same coin. The reason why this concept is important will become clear to you in future posts.

Sounds logical, eh? Problem is, most Canadians fail to understand this concept. For some reason, we get all excited when our savings grow by a higher amount than we had anticipated. But we fail to understand the consequences of debt growing at the same rate. There is, in fact, no difference!

There are a number of lessons we can learn from the above-noted concepts, many of which I will describe in upcoming posts. The remainder of this post will describe the first lesson of debt.

Lesson #1 – Credit Card balances are bad. Very, very bad. Check the interest rate in the upper corner of your next VISA bill. It very well might read 29%. That number is astronomically high in finance circles. To illustrate a very practical lesson here – suppose you had a balance of $10,000 on your VISA bill that you’re having trouble paying off. Suppose also that your total savings in the bank equal $10,000, which are invested in GIC’s, paying you 2% annually. What should you do? Should you pay off the VISA balance by cashing your GIC’s, or keep your only savings in the bank?

I hope this post taught you the right thing. In case it didn’t, let me explain. Debt is really negative savings, nothing more and nothing less. So if you want to increase your overall wealth, obviously you should pay down the credit card balance, because the interest rate is so much higher on it than the rate of return on your savings. In fact, I’d probably advise a couple to liquidate every last penny of their savings (there are exceptions of course!) to pay off their credit card debt, because there is little chance your savings will ever produce a rate of return that will match a credit card interest rate.

So lesson number one is: Never, ever borrow on a credit card (if you know you can’t pay it back), unless you are super-desperate and have tried every last means under the sun to borrow money at a cheaper rate. And if you already have a credit card balance, pay it off immediately. Even borrow money to pay it off. Beg for the money – whatever it takes. Because you will never earn a rate of return on your borrowed funds that will out-perform your credit card interest rate.

This first lesson may seem obvious, but incredibly, I have seen a study showing that only 15% of recent college graduates in the US do not have a credit card balance owing. Do not fall into the trap. Do not incur unpaid credit card balances!

Next week, I will further our discussion on credit cards (believe it or not, there are some positives for having credit cards!), before moving on to discussing mortgages.