The Truth About Credit

In order to build a plan for our future, we must find the many leaks in our financial ship and patch them all. As one of my very successful clients put it for me, she was 85 and owned several businesses and pieces of real estate, “I don’t know any other way to make money then by saving money.” That is a very true and profound statement.

The first step in making money and keeping it is to stop losing what you already have.

The first step in making money and keeping it is to stop losing what you already have.

Whenever you choose one place to use your money, there is an opportunity cost associated with using it in an alternative minimum savings or investment plan. The debt to wealth equation is a simple math tool I developed for use that states how much your debt is worth in accumulated dollars if it were invested instead of paying credit down.

The debt to wealth equation is a simple math tool I developed for use that states how much your debt is worth in accumulated dollars if it were invested instead of paying credit down. This is usually called the opportunity cost. Whenever you choose one place to use your money, there is an opportunity cost associated with using it in an alternative minimum savings or investment plan. If we consider using a 3-month Treasury bill currently returning 3% as a possible opportunity alternative, and our interest rate for the credit is 8%, then our opportunity cost using the debt-to-wealth equations is 3 + 8 or 11%. We are sacrificing gaining 3% while also paying out an additional 8% in interest.

Let’s look at an example of the debt-to-wealth equation in action. There can be many variables to consider so we will just utilize one scenario to put the point across. We will start with a $1,000 debt for simplicity. We will use an average debt interest rate of 10%, even though this is probably low in most cases. We want to be conservative here so as not to be over-the-top with our example. Let’s further assume we can get a modest interest rate of 5% on the money instead if it were saved or invested. I would have 255% more money if I did not spend the $1,000 on debt and could invest that money instead at only 5%.

In this case if we were to invest the money at just 5% for five years instead of having to pay credit, we would have roughly $1,275. At 10% interest on the debt we would pay approximately $1,275 to pay the $1,000 off in five years. If we saved the money we would have $1,275 instead of losing $1,275 that gives me a swing of $2,550. Although my opportunity cost seems low at 5 + 10 or 15%, the amount of cash I would gain is significant. Dividing $2,550 by my original $1,000 gives me a debt to wealth swing of 255%. I would have 255% more money if I did not spend the $1,000 on debt and could invest that money instead at only 5%. That is the debt to wealth equation. Now multiply these numbers by the amount of real debt you may have. Do not exclude anything, including your home if you own one or any automobiles. These are all debts.

Three to five years of self control and you could never need credit again.

Yes, maybe you wouldn’t own as nice a vehicle initially if you stopped using credit, or wouldn’t be able to upgrade your vehicle as often, but at debt to wealth ratios above 200%, how long do you think it will be before you can buy the kind of vehicle you would like with cash? Three to five years of self control and you would never need credit again. You would be earning interest instead of paying it and that is one of the real benefits of this course.

 

What is net worth? Your net worth is simply your assets minus your liabilities. What you have minus what you owe. If I own $200,000 in cars, homes, and other assets and I owe $175,000 in mortgages and other debts, then my net worth is $25,000. The object of this course or any other financial training course is to increase your net worth. We increase net worth by increasing the cash flow that is available and utilizing it to increase our assets over our liabilities. Simply, you take your excess cash and purchase assets. That is obviously an oversimplification, but it is accurate.

The problem, or difficulty, most Americans face today is that their liabilities equal or far exceed their assets. This is where the debt to wealth equation should show a significant ratio. This course will help you develop methods and lifestyles that will change the equation to increase your net cash flow in order to purchase more assets for your personal portfolio. Most Americans are earning enough money to radically change their lives. They are just giving it away in debt. Let me explain that further.

You might think you are good with your money, and maybe you are. If you are, then our planning portion will be simple for you. First let me ask you a question.

Did you know you’re a millionaire in the making?  

If your household income is $25,000 a year and you have a working life of forty years, that’s $1 million! If your household income is $40,000 a year and you work twenty- five years, it’s a million also. This money will travel through your hands so to speak. You have control over where it goes and how much of it is wasted. So where is all your money going?

Consider for a moment how many items you have purchased over time, items that you really did not need or eventually you totally lost interest in? We are coerced every day into buying many things that are really irrelevant to our lives in the long run. Maybe it was OK to buy them at the time, but was it important enough to rob us of our financial future.

The media, advertisers, and credit companies alike all realize you are worth a great deal of money over your lifetime to them. They mean to suck every penny out of you they can having designed their advertisement, news programs, entertainment programs, and literally every aspect of their contact and communications with you to make you do exactly what they want, buy everything they are selling. 

Once more I remind you of what Jay Chiat former chairman of ScreamingMedia, an Internet Company and partner in TBWA/Chiat/Day, one of the world’s ten largest advertising companies, in his article Illusions Are Forever in essence comes clean on the subject of the media’s real agenda. (Chiat, 2000) 

Advertising—including movies, TV, and music videos—presents to us a world that is not our world but rather a collection of images and ideas created for the purpose of selling. These images paint a picture of the ideal family life, the perfect home. What a beautiful woman is, and is not. A prescription for being a good parent and a good citizen. The power of these messages lies in their unrelenting pervasiveness, the twenty-four-hour-a-day drumbeat that leaves no room for an alternative view. (Chiat, 2000, p. 166) 

We have to break free of the unrelenting drumbeat and take back control of our spending and our lives. I personally mute the commercials on my TV, if I watch TV at all any more. I have satellite TV and with hundreds of channels available it is almost impossible to find anything on that has any intellectual character at all. Most of the programming is mind candy. It is teaching us and our children to turn off our minds and do what we’re told- buy, buy, and buy. And the ultimate problem this pressure to buy creates is serious debt!

Debt is one of the biggest factors relating to how well and how fast we will build our retirement wealth. There is a direct negative correlation to how much debt one carries to how much money they can save. In order for us to understand the negative impact debt has on our retirement plans, we will illustrate it with an example of a $25,000 car versus the $45,000 car.

If we were to finance our purchase on one of these cars, the difference in payments would run about $375 a month if our loan was at 2.5%. While everyone has seen the 0% adds out in the marketplace, most people will not qualify for those interest rates. This is a sales technique utilized to get people through the door and then switch them to a slightly higher rate of interest. It is called bait and switch. Think about it. If you came ready to buy a car and your desire was to drive it home that day, would you change your mind if the rate went up to a mere 2.5%? The majority of Americans will not and that’s what auto dealers count on and do just that, bait and switch. So for our example here we’ll use 2.5% because that is about the best interest rate the average American will get.

We only want to deal with the difference in price at this point. The difference between the costs of the two cars is $20,000 and we will be financing that difference at 2.5% for five years. You can now get five year financing on new cars. This increase in the time for financing has two big benefits for the car dealers. First, it allows them to get the payments down on the larger cars to where most people can afford the monthly payments. Second, it allows the auto dealers to earn more interest because the loan goes a year or two longer. As you are about to find out, the real money in the auto industry is not in the price of the car, but in the interest earned on the financing. It doesn’t matter to the lenders whether it is a car or a dish washer as long as they can stretch the payments out at interest. Once they’ve approved your car loan and you make a few payments on time, they will send you one of their low interest credit cards because you may still have few more pennies left in your monthly budget they can suck out. 

Remember, everything additional above your needs that you spend your money on, is coming out of your future retirement income!

The monthly interest works out to .21% per month. That seems really low doesn’t it? That roughly works out to be about $42 a month of the $375 payment that’s interest. That adds up to an additional $504 a year in interest that we are paying for the more expensive car. For our 5 year auto loan, it comes to $2,520 in additional interest beyond the $20,000 more it costs to own the second car, or $22,520.

OK, so now when you are faced with the increase in cost per month of $375, you might consider that to be reasonable and affordable payment, many people do. But what if the dealer came to you and said “based on your credit rating we can only allow you the payment of the $25,000 car, so if you want this other car you’ll have to make a $22,520 down payment.” Even if you had the money in the bank, would you pay it to own the more expensive car? No! But, $22,520 additional is what it is really costing you in real dollars!

It gets worse! What if instead of buying the more expensive car, you had invested that $20,000 over a five year period, $4,000 a year in a tax-deferred retirement plan. Let say it was a safe and secure savings plan like a fixed annuity; one where you couldn’t lose your money and would get you a potential return of about 4%. This is a realistic and conservative savings plan. Let’s further assume you make only five payments annually of $4,000 for 5 years and then stop. We will also assume you wanted to access this investment in 20 years total.

After the first 5 years, your annuity would contain $22,531, roughly the same amount you would have paid the auto-finance company. If we kept up the same rate of return without adding any additional money for the following 15 years, your total return would add up to over $40,000. That is the real cost of the loan to buy the more expensive car. Where would this money go? It would go to you instead of the finance company. Therefore, if you had purchased the more expensive car at the ridiculously low interest rate of 2.5% you would have ended up losing over $40,000 over the twenty years!

Now I ask the question I asked earlier, would you be willing to make a $40,000 down payment to buy that more expensive car and pay potentially a total of over $85,000 for that $45,000 car? When it is proposed as only $375 more a month, it is so much easier to rationalize the purchase. From a psychological standpoint your brain sees the monthly payment as far less than the actual purchase price. That’s why car prices are advertised in monthly payments and not actual total cost. This is the true impact of credit on our future. If they advertised the car as costing $85,000 of your retirement money would you be interested, would the auto dealers sell any that way? Look how many they sell by only quoting the monthly payment, millions each year. This is a Debt to Wealth Equation resulting in a 425% loss of future retirement wealth over the additional fifteen year period.

How’s that for an opportunity cost?