All Liabilities are Not Equal
I know you’re going to be shocked, but just like the fact than All Assets are Not Equal, the same holds true for liabilities. A liability is something that you owe. Most liabilities are loans of one form or another. I’m sure you’ve all heard how bad credit card debt is, this is a clear example of a bad liability. Any time you are borrowing money to purchase anything other than an good asset you are incurring a bad liability, I’ve talked about this before. The worst of the worst is to use debt to purchase a service. While reading blogs the other day I stumbled across a guy who was going to finance his Honeymoon with credit card debt. This is a huge mistake, and is incurring the worst kind of debt. If you are putting “fun” stuff on your credit card because you have not saved the cash for them, then you are simply living beyond your means. In this case Matt simply can’t afford this Honeymoon and would be much better spending less, perhaps much less. How about a nice camping trip at a National Park Matt?
Good liabilities are those where you are borrowing money to purchase an asset that will return you more than the liability will cost. An example of this was that I took about $20,000 out of my home equity when I refinanced by house back in 2001 and put that money into the stock market. In my case it was in the Mathews Pacific Tiger Fund. I purchased 2,809.2 shares @7.15 on Oct 16th, 2001. I ended up paying about 4.75-6% for that money (I refinanced again in 2003), but those shares are worth $25.12 today (4/20/07). To borrow that money for 5 1/2 years cost me approximately $6,000, but returned about $50,000. I could sell my shares to cover the original $26,000 loan + interest and still have $44,000 left over. In this case I got very lucky and hit a jackpot investment. But even if it grew much less I have an asset in my hands to pay off the loan with. Compare this to Matt who will have to use future earnings to pay off the credit card debt he is going to take on.
Some rules of thumb
- Never take on debt to purchase something “fun”. If you will have fun spending the money don’t do it with borrowed funds. Save first, then have fun spending the money.
- Never borrow money to buy anything that is not a good asset.
- Borrowing money, even for good assets increases your risk. What would you do if the value of the asset you purchased with your borrowed money lost half its value? Beginning investors should try to never borrow money.
But Kit, what about borrowing money to buy a House or a Car, is that bad? As with most things, it depends. I’m not a fan of car loans at all. The only time you should be borrowing money to purchase a car is if you absolutely need that car for basic transportation. In this case borrowing the money will allow you to increase your income, because you can now get to work, over what it would be without the car. But there is no real excuse for buying anything more that basic transportation this way. If you are spending more that $10,000 or so on your car, you should not be borrowing the money, just buy a cheaper car.
The argument that you need a car to hold down a job, and thus borrowing the money to buy the car is a good financial move can hold water. But only if you are buying the most inexpensive car that will meet that basic need. If you are borrowing money for a BMW then you are incurring bad debt. If you want an expensive car then you need to save the money first and then buy that trophy car. Hey it’s your money, spend it any way you want. But don’t try to convince me that you job requires you to have a certain image and thus a certain car. I’m not buying any of that.
Home Loans are even more complicated. Because your home is both an investment, and consumption. In addition, it’s not realistic to save $200,000 or more for a home before you make the purchase. So a decision to borrow money to purchase a home can be a good thing. But you should be very careful about the kind of loan that you take. Any time you take any loan you are increasing risk. Even if the asset drops in value you still have to make payments on the loan, and if you sell the asset you must pay off the full value of that loan, even if the value of the asset does not cover that loan.
Consider a house purchased with only 3% down. You are immediately in the hole because to sell a house you have fees to Realtors and other costs that can run between 5 and 8% of the value of the house. You may also have to drop the price below market value if you are in a hurry to sell. All this means that unless you are putting at least 10% down on a house you are counting on the value of the house to go up to get you out of the situation. For the past 4 years prices have been rising so fast that it has covered everyone taking this risk. But there is no guarantee this will continue. In fact, prices have risen so far so fast it is likely that prices may stay flat or even slowly decrease over the next few years.
I believe this is the reason why traditionally a 20% down payment was required to purchase a house. With 20% down the odds of your ending up in a bad situation is significantly reduced. Therefore, I believe that unless you can afford to put down 20% to purchase a home you can’t afford it. Either save more money, or buy a cheaper house. According to this about 80% of the people are purchasing more house they cannot afford. From what I’ve seen that’s probably not that far wrong.
The biggest mistake that most people make is spending more money than they have. Easy credit and taking out bad loans is what allows people to make this mistake. It also can hide the effects for years. But eventually it will catch up with you. By paying with cash or doing without you will already be in an elite class of people who take responsibility for their own actions, are willing to live within their means, and are on the road to financial success.
Full Disclosure: I don’t have any car loans, but I do have a Mortgage on my house. I put 20% down, and the loan to value ratio on the property is now about 50%.
April 27th, 2007 at 5:14 am
I agree completely that not all liabilities are created equal and that my Fiance and I financing our honeymoon on our credit cards but there is a reason for it other than just ‘Fun’. We’re using the credit cards because pretty much all our other money is tied up with the wedding, we’re expecting money from both families that they’ve told us to expect which in turn will go to paying off this honeymoon.
I got myself into huge debt by living beyond my means with ‘fun’ purchases on my credit cards and I’m sill paying that down, I wouldn’t make the same mistake twice at least not at the price of a honeymoon. Credit cards should not be used when you have no means to repay them but making an advance purchase when you know you will have the money isn’t necessarily bad as long as you’re willing to incur the additional finance charges.
April 27th, 2007 at 1:09 pm
Firstly let me say, Congratulations on your upcoming wedding. Managing your finances is an important aspect of a good life, but finding a life partner is even more important.
My concern is that you seem to be in a pattern of spending first and paying later, rather than saving first and spending later. To me this is the primary distinction between those who are wealthy and those who are going to be wage slaves their entire lives. In the post I reference in the article you say that you had a goal in January of saving $7000 for your wedding and $4000 for your Honeymoon. In the report you say that you didn’t make any progress on either of these goals, not even partial progress. It’s one thing to shoot for $7K and only save $5K, but so shoot for $7K and not save anything?
There will ALWAYS be something out there that you really want to have or do that is going to cost money. You absolutely have to acquire the discipline to say “I can’t afford that”, or “I don’t want to afford that”. If you don’t you will be a wage slave your entire life. Now it’s the wedding and honeymoon, next it will be a house, then furnishings for said house, then it will be a child, etc. Each of these things are things that people tell themselves they owe themselves, and if they just acquire them, happiness and a good life will follow.
The entire capitalist system is built on some very smart people working very hard to convince you that there are things you really want to have right now. With the advent of easy credit they also allow you to buy now and pay later. This is a trap, don’t fall for it.
I hope I’m wrong in my assessment of your situation, but it sure seems like you are better at talking the talk, than walking the walk.