Not Negative is Positive

No doubt you've heard a lot about the current "credit crisis." For those who haven't watched TV, picked up a newspaper, or opened a website in the last 2 years, the current credit crisis briefly refers to the fact that many borrowers today aren't able to make their loan payments, and consequently the lenders are losing money, which causes them to be more hesitant in lending. You see that this is a potentially vicious cycle, which is why everybody is worried that it is going to just cripple our economy. I don't want to make this blog into a Wall Street Journal article, but I think that we can all take away some lessons from this current crisis. First of all, let's go back and examine the origins of credit.



Did you know that about 40% of Americans are in debt, 75% of households have at least one credit card, and 70% of homeowners have a mortgage? Now most personal finance books will tell you that a core principle is to not spend what you don't have. That seems like intuitively prudent advice, but why then do most people not follow it? Why is there even credit to begin with? The answer is that credit generates business. Credit is a concept engendered by businessmen, because they can make make money lending, through the interest they charge. But it is not just the fault of the lenders. Borrowers generally welcome credit (hence the high number of people in debt), because there are 2 types of borrowers. One is other businessmen who feel that they can make money borrowing at a low interest rate, and then using the money to make profits that are more than their interest payments. And then there's the type of borrower who thinks that this is a chance for them to own something they really want but can't afford at the moment...ummm, if that's not the classic spend-more-than-what-you-have, I don't know what is. This latter type of borrower unfortunately is your average consumer...yes, come out from behind the tree, you know who we're talking about.



Debt gets a bad rap...I mean, it kind of sounds like "death," (and feels like it sometimes) but not all debt is bad...just most of it. You've heard people say student loans are good debt. Why? Because usually they have very low interest rates. But be careful to generalize, because I've taken out some loans during my schooling with interest rates as high as 10%. When you look at debt, you are confronted with two scenarios: 1) what do you do with your current debt, and 2) when should you take out new debt?



Let's examine the first scenario--what to do with your current debt. Is it as simple as, "Pay it off!?" Well, it could be that simple, but if you followed that rule, you wouldn't be maximizing your investment returns. Let's look at an example. Let's say you have a student loan debt of $1000 at a 2% interest rate. You have just received your latest paycheck, and you've been paying attention to the previous blogs, setting a mini-goal of saving $400 a month. You plan to put $300 in your retirement account and $100 in a savings account. Your retirement account is invested in the stock market, and that generates on average a 9% annual return. Your savings account gives you 2%. So, given this situation, should you use some of your savings to pay off your student debt? (I have to interject here and clarify that you should always pay at least the monthly minimum, if you want to have a semi-decent credit score. What we are talking about here are payments on top of the minimum, so you can actually pay off the debt.)




One can make an argument that instead of putting $100 into your savings account, you should use it to pay off your debt. The reason is that your savings account return will be taxed, and so you're going to really earn about 1.5%, and then it's a queston of owing 2% more vs. gaining 1.5%. However, my recommendation would be to not touch your savings account, since that is your emergency fund. What about your IRA? That's a no brainer--owing 2% more or gaining 9%. Contributing to your IRA will give you a net result of gaining 7% of your savings at the end of the year, and paying off your debt will cost you a potential gain of 7%. So you see, paying off debt is not always the right move.



Let's change the example. Let's say instead of a student loan debt, you had a credit card debt at an interest rate of 15%. Again, in my book, your savings account should be hands off for emergency purposes. Should you pay off your credit card debt or contribute to your IRA? And the answer is pay off your credit card debt. Think about it, it's a question of owing 15% more vs. gaining 9%. The end result would be you owing 6% more in a year. Not negative is positive--sometimes not owing more is as good as gaining. The take home point is, if you have any debt that has an interest rate>9%, paying that off takes priority over saving.




OK, now you know how to deal with your current debt. What about situations where you're thinking about borrowing more? Let's say you're interested in buying a TV, and these days it's gotta be a flatscreen, right? OK, a flat screen it is, which will set you back anywhere from $500-$2000. Let's just pick an easy number, $1000. You have $500 in the bank, so there's no way you're getting the TV, right? The salesman sees a moment of hesitation in you, and offers you a way to finance it. He/she says the store will lend you $500 at a 10% interest rate. Sound like a good deal? Yes...to the salesman. Not only will he/she profit from your purchase of the TV, he/she reaps the interest from this loan. This is clearly not a situation where you should borrow money.




You tell the salesman that you refuse. Then he/she comes back to you with a deal where you can borrow money at an introductory 0% annual percentage rate for the first 12 months. That means you won't have to make any payments for a year, plus there is no interest added to your loan during that time. They run your credit score, and you're approved for a $1000 loan. What now?




Being this is a personal finance blog, the best thing obviously is to not to buy anything you don't really need, but you've already heard that one. Hopefully, we're past the stage where we seriously shop for things we don't really want.



So I say you take the TV home, but at what cost to your bank account? The correct answer is zero, because think about it. Someone is giving you a free sum of money for a year. Why are they doing this? Because they're betting on the fact that you won't have the $1000 after a year to pay them back, in which case, they can then charge you a gagillion percent interest. But we won't be that negligent, and we are checking our finances at least once a month, setting the mini-goal of paying back the $1000 after a year. Plus, we're going to set this free money to use, putting it in a savings account throughout the year and generating a profit for ourselves!



See, there are times when it's actually OK to borrow. But don't go out and agree to every great loan that comes your way, because accumulation of debt leads to a bad credit score, and plus, you're not a banker who actually has the time to manage all these loans. The credit score is a weird thing...too much debt is bad, but moderated debt that you pay off consistently increases your score. Anyway, that could be a topic in itself.




So let's go full circle back to the current credit crisis. Many people blame the lenders, the banks, for offering all these aggressive "subprime" loans, ones which borrowers would unlikely be able to pay in the long run. But from our credit discussion, credit is embraced by both lenders and borrowers. Borrowers also had a responsibility to make sure they could afford the loan. That is the main lesson for us. Credit has become an essential in personal finance, and managing your money not only includes how you deal with what's in the bank, but how you manage your debt as well.




Until next time, may you make some moolah.