What’s keeping you poor this September?
Many of our new clients have trouble wrapping their heads around the idea of financial independence. It’s not only contrary to the lifestyle they were brought up to expect, it seems impossible to retire young. I often hear “I don’t think I’ll ever be able to retire” from people who fall squarely in the top quintile of the US income distribution. The biggest reason for this, I think, is debt.
Debt is not only common among Americans, it’s acceptable and expected. This is a troubling phenomenon because debt is arguably the greatest danger in personal finance and is incompatible with financial independence. The most damaging symptom of debt is that it creates recurring expenses that force us to continue working to pay for them. To understand why, let’s break down that last sentence into two problems:
1. Debt creates recurring expenses: “You have to spend money to spend money”
Let’s assume that you want to buy a house. You find a house that you like and tell the seller that you want to buy. The seller says she will sell you the house for $125,000. “That sounds fair,” you reply, “but I don’t have $125,000.” Fortunately, we live in a capitalist society where everything is for sale, so if you don’t have money, you can buy it.
How do you buy money, you might ask, and how much does it cost? To explain, let’s assume that the seller tells you to go to the bank and ask to buy some money. You go to the bank and tell the banker “I need $125,000 to buy a house.”
“Great!” responds the banker. “How much money do you have now?”
“I have $25,000.”
“Excellent,” replies the banker. “I’ll give you $100,000 now to cover the rest of the bill and you can pay me back $105,000 in 10 years.”
To make things easier, you give the banker your $25,000 and he writes you a check for $125,000 to pay for the house. You agree to pay the banker $10,500 every year for 10 years until the loan is paid off (this oversimplifies the way amortization works in real life, but it’s sufficient for our purposes here).
Here we can see that the price you pay for money (i.e. a “loan”) is the interest rate, in this case 5% of $100,000 or $5,000. So when you pay for something on credit, whether it’s a house, an education, or a car, you are buying not only that product, but also the money to pay for it. That’s an extra $5,000 you paid for nothing other than the ability to pay for the house, which is no less annoying than paying a five dollar “convenience fee” for buying concert tickets online.
2. Debt forces us to keep working: Our debts and our lenders “own” us
When you bought the house in the previous scenario, you obviously didn’t pay $5,000 up front for the $100,000 loan (if you had money lying around, why would you take out the loan?). Instead, you pay $5,000 divided over the repayment period, in this case 10 years. This unfortunate agreement is also known as a “mortgage,” which comes from the French phrase meaning “death pledge.” Seriously.
If you owe $10,500 a year for the next 10 years, are you likely to retire in the next 10 years? Probably not. This is why debt is the number one reason we are forced to keep working year after year. A $100,000 loan with 5% interest creates a recurring expense of $10,500 per year (again, this is oversimplifying because most loans are calculated through amortization). Congratulations, you have become a wage slave — another American who happily wakes up every weekday morning to earn money — that you then owe to someone else who is probably richer than you.
I hope it’s starting to become clear that when you take out loans to buy things, you are now owned by those things, and by the lenders who sold them to you. In the 1999 movie Fight Club, Tyler Durden tells the Narrator that “the things you own end up owning you.” This statement is true, but ironically it’s even more accurate when you only sort of own things because you bought them on credit. Your new car that you just bought for 50 percent down? You only own half of the car, but you’re now working for it full time, and for the dealer who sweet-talked you behind the wheel.
There are legitimate reasons to take out loans, and every person’s financial situation calls for different considerations, but ultimately I hope I’ve demonstrated that debt is generally a barrier to financial independence and early retirement. Americans as a whole have an attitude towards debt that is much too casual for my comfort level. In future blog posts, we’ll discuss other aspects of personal debt and strategies for avoiding debt. If you’re concerned about your own debt and how it affects your finances, please contact me at firstname.lastname@example.org.
Alejandro is a financial planner with Monte Largo Financial Advisors LLC.