“All Debt Instruments Are Not the Same”
There’s a big misunderstanding between debt vs leverage. There’s a reason for using debt instruments like credit cards as well as financing automobiles and homes, but they are not all the same. It is true that upon concluding a transaction with anyone of them, you will end up owing money to someone. You will have various options and methods to pay, but that’s about all they have in common.
This misunderstanding and misuse of credit card debt have resulted in Americans carrying enormous amounts of revolving debt. This, in turn, compounds the problem by lowering credit scores and increasing interest rates—with you potentially becoming a slave to credit cards and other financial institution payments. The list goes on and on.
Don’t get me wrong. Credit cards are an important tool, providing a very convenient way to purchase things. They can also provide you with your first red flag that something is not right with your finances. The point is, if you’re not paying off your credit cards in full at the end of every month, you are living beyond your means. In other words, there is more money going out than coming into your financial life. And you are choosing debt vs leverage.
Problems of Debt
A positive cash flow is essential to financial success and should always be the priority maintained. Credit cards are not instantaneous loans. They do have value with certain rebates, online convenience purchases, and the blessing of not having to carry cash. They also offer a way for huge companies to make lots of money off of the money you work hard for. If you are not strong-minded and stubborn, credit cards can and will set you up for total failure.
The first step is to see that a credit card is not the same as a home mortgage or auto loan. Blowing your budget is the biggest disadvantage of credit cards in that they encourage people to spend money that they don’t have. Credit card companies charge enormous amounts of interest on each balance that you don’t pay off each month. On the other hand, certain debt, like home loan debt, has lots of advantages. Here’s an example of what I call “The Wise Use of Leverage” and a perfect example of debt vs leverage.
So Let’s Buy A Home!
For most mortals like us, when you buy a home, you are not using your own money. You are using other people’s money— money from the bank. This allows you to put down a small amount, the downpayment as it’s called, and the bank will finance the rest. Home loans typically have long-term payment arrangements. Amortization Schedules is the fancy term for the chart that shows those arrangements. You can pay a very small amount each month and still have ownership of a fairly expensive asset.
It’s a good deal because homes (if you maintain them) typically appreciate over time. And bonus, the government gives you incentives by allowing you to deduct a portion of your mortgage interest from your taxes. That’s why I call financing a home a wise use of leverage. Purchasing a home can be within your reach with proper planning, and most mortgage companies are not doing background checks.
Let’s look at this example
Two people are each going to purchase a home. Both homes are the same size— same extras, same lot size, garages basically the same. Everything is the same, including the price of $100,000. We will consider Mr. & Mrs. Cashman and Mr. & Mrs. Leverage. By the way, there are plenty of homes in the United States at a price tag of $100,000.
The Cashmans bought a home valued at $100,000 using all cash, which includes closing costs. The Cashmans were happy campers. They lived and enjoyed their home for ten years, and then they decided to sell it. The Cashmans were able to sell it for $200,000! Sweet! The transactions are as follows:
- Investment $100,000
- Sold for $200,000
- Profit or gain of $100,000 or 100% return without consideration of taxes and expenses
Mr. & Mrs. Leverage, on the other hand, purchased a similar home valued at $100,000 but choose to keep $80,000 for investment. They used only $20,000 as a deposit on the house. They took out a mortgage for $80,000. Their monthly payment was $454.23, not including taxes and insurance. Mr. and Mrs. Leverage sold their home ten years later for $200,000. They had a balance of $66,033.05 still owed to the bank. After paying off the first mortgage, the net proceeds were $133,967 minus Mr. Leverage’s $20,000. The transactions are as follows:
- Investment $20,000 of their money and $80,000 from the bank
- Sold for $200,000
- Monthly payments for 10 years: $54,507.60
- Paid back the bank $66,033.05
- Profit or gain of $59,459.35 without consideration of taxes, expenses or tax benefits
So, after all is said and done, the Cashmans doubled their money; on the other hand, the Leverage family made almost three times their money by using the bank’s money. Plus, the Leverages invested the $80,000 in the S&P 500 for the entire 10 years, which returned 10% annually. This caused the Leverages’ stock portfolio to rise to $216,563.32.
10 Year Return:
- CASHMAN – $100,000
- LEVERAGE – $196,024.72
There’s a big difference between debt vs leverage. And a big difference between credit card debt, installment notes (auto loans), and home mortgages (the wise use of leverage). Bottom Line: Misuse of credit cards destroys wealth. Automobiles are a depreciating asset and, in general, a very poor investment and not the best place to use the bank’s money. When it comes to automobiles, the best thing to do is buy high quality used cars, if you can, with all cash. Appreciating assets or assets that can generate income are the best for financing. Just remember, “Just because they all have an amount owed and monthly payments…..All debt is not the same.”