Wealth Skills

Debt is a choice

Posted on 18 November 2009

We borrow money either to purchase an asset (home, car) or to cover our current spending. When we borrow money we enter into a contract to repay the money with specified terms: period of time, cost of borrowing (interest rate), payment schedule and amount. Debt is our liability.

Why do we take on debt? We either want something now and are unwilling to wait for it, or we want to maximize growth of our net worth.

Debt for expenses. Sometimes an unexpected expense happens and we borrow money to pay for it because we don’t have cash. When we don’t have cash for the unexpected expense it is because we spend all the money we earn on an on-going basis.
With any debt comes the obligation to pay it back. The payments lower the amount we have available for other things. Any time we acquire new debt, we’ll have less for other things in the future. It is easy to see how spending all of our earnings can lead to having debt, which in turn will lower what is available for spending in the future. It can quickly turn into a vicious cycle of not having enough money.

Debt to build wealth. Sometimes we are willing to acquire new debt to purchase an asset. Some assets are classified as appreciating assets, for example a house (despite what has recently happened in the Real Estate market houses are appreciating assets in the long run). Other assets are classified as depreciating assets, for example a car. Depreciating assets lose value over time. You know that a car will be worth less the longer you use it.
Taking on debt to acquire an appreciating asset may result in building wealth. To build wealth by taking on debt it is important to consider:

• The cost of borrowing the money (the interest rate) vs. potential appreciation of the asset you are considering buying
• Are there other assets you could purchase with the money?
• Any additional cost of maintaining the asset
• The impact of the new debt payment and maintenance cost on the quality of your life
• The value you’ll derive from ownership of the asset
• Is the value greater than cost?

Debt is a choice. Sometimes it may seem we have to acquire debt to survive a circumstance. In reality those situation may be alleviated when we systematically spend less than what we earn today.