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"Gentlemen prefers bonds",
Unknown.
The
incredible amount of consumer debt, which is growing faster than income, and
its effects on the personal finances of millions of people around the globe
(yours truly included); has led us to believe that debt is a bad thing... a
very bad thing. But, is it really that bad?
I have
a group of friends who believe that ALL debt should be avoided; they always
think in terms of cash. They encourage people to plan all their purchases
(even big ticket items), to be made on cash or equivalents. Is that a
financially sound idea?
The
statistic about bankruptcies in America tend to assert the aforementioned
school of thought; and my own experience had taught me that debt is bad for
our financial health. Since I entered college (circa 1982) I had been subject
to debt. When I entered the work force I "learned" about consumer
loans (issued by banks), then the mother of all personal credit instruments
(credit cards)... You know the story; it is something familiar to at least 95%
of us: a few credits here, a few credits there and pretty soon we are talking
about some serious debt load.
When I
reached that point, I came acquainted with the fellowship of cash-is-king pals. They
showed me how I was compromising my future by living on perpetual debt. I worked
very hard to pay my living expenses, my debt amortization and nothing more. If
I ever wanted to treat myself on holidays and my birthday I had to sink
myself more in debt. They made me wonder what could happen to me if my income
source suddenly disappeared (gulp!).
I was
decided to get rid of all my debts and swore that from now on, I would made
all my purchases with cash (or equivalents). That resolution was reinforced
after I meet the Fools and read all the debt-bashing materials that they have
in their site and books. But as I read books about investing I learned to make
frequent what-if scenarios, and suddenly my view about debt changed again...
Let's
say that we have $40,000 in cash or equivalents and we want to buy a new car
which after the down payment would left us with $30,000 in debt to be paid in
5 years. My cash-is-king friends would buy the car in cash (imagine the face
of the vendor when you offer them to write a single check NOW!) Let's say that
we can get a 8.5% loan and we put our cash
to work (i.e. we invest it in the market). As long as we earn more in interest
or capital gains than the interest we pay for the loan, we are doing better;
although we wont be able to impress the car vendor. OK, how do we know if we
are going to get ahead? What would be the lowest limit? Do you like a little
test?
If
the best you can find is an investment that pays an annual compounded rate of 8.5%
(the same rate of the loan), would you take it or would pay cash instead?
Think about it. Do you have a decision? OK, the answer is... (drums
rolling)...
TAKE
IT!!!
What?
Yes! Take it. Using a loan calculator utility (Lotus 123 comes with a nice
loan amortization utility that include totals); we learn that over the 5 years
we are going to make monthly payments of $615.50 and a total of $6930.00
in interests. Because the interest is calculated over the average daily
balance, it will be reducing as we are paying the loan. Now, our investment
would give us different returns depending on the type of the investment. I am
assuming that we re-invest the gains regardless of type.
If the
investment is in stocks, we use the services of a deep discount brokerage firm
($8.00 per trade), we use a buy and hold strategy and sell at the end of the 5
year period we get:
((30,000.00-8.00)*1.085^5)-8.00
which is the same as ((30,000.00-8.00)*1.085*1.085*1.085*1.085*1.085)-8.00
totaling 45,089.67 For a net gain of 15,089.70 But because of the capital
gains taxes of 20% (10% if you are in the 15% tax bracket) we are left with
"only" (45,089.67-(30,000.00-16.00))*0.8 = 12,084.54 (The IRS
allows you to deduct the broker commissions from your gains).
Now,
because we paid 6,930.00 in interest on the 5 year loan, our real gain is
12,084.54-6,930.00 = 5,154.54
In this
example I used only ONE stock because those new Spiders, Diamonds, Webs and
the Nasdaq 100 TR SR 1 products, all trade like stocks and provide reasonable
diversification.
You
should NEVER, EVER compare debt vs. investments on a rate basis only! Do your
due diligence and you will be rewarded.
Since
1926, the average annual compounded rate of return of US Stocks is 11% and
while there are no guarantees that any 5 year period would give us that
return, taking the risk is worthy.
Debt is
like cholesterol, there is good cholesterol and bad cholesterol. Better yet,
debt is like alcohol; well taken it will benefit your health, taking it in a
binge, will destroy you.
The
benefits of debt apply only if you HAVE funds to make the purchase in cash.
Therefore the limit of "healthy" debt are dictated by our funds.
Once you take a loan, consider the invested funds as mortgaged. Something like
this: Total Investments and/or cash equivalents - Total Debt = Equity As long
as the Equity can be written with black ink, the debt is still
"healthy". And please, be careful about what do you call an
investment. If you count non rental real estate property, cars, boats, art
collections and other bogus as investments; do yourself a favor and stay OUT
of debt entirely.
Another
important factor to consider is cash flow. In our example, the loan would
require that we make payments of $615.50 per month over the 5 year period of
the loan. We need to make sure that the payments can be covered with our
current total income. Black inked equity with a red inked cash flow is not a
good sign of a well run business. |
