“Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channeled from the idle rich to the industrious poor.”
~Niall Ferguson, The Ascent of Money
In the last several chapters, we discussed housing, food, clothing, and transportation expenses, as well as saving AT LEAST 10% of your income. Based off the standard advice discussed in those chapters, you may/should have already spent 60 – 70% of your income on these expenses. If you have debt (excluding your mortgage), you’ll have to add this as an expense as well. So why is debt so bad? Debt is so bad because it exposes you to many risks and can be like a noose around your neck. As your debt increases, interest rates rise, your income reduces, or you experience an emergency, the minimum payments can increase and it will tighten the noose and may force you to reduce other expenses until possible bankruptcy. Before we go too far, though, let’s look at what debt really is and how it started.
HOW IT ALL STARTED
Debt truly started when banks started using fractional reserve banking concepts. This is an important concept to understand because it impacts interest rates. Fractional reserve banking is where a bank has (for example) deposits and uses those as a “reserve” to issue loans in excess of its deposits. People don’t often need immediate access to their money, so banks can take on additional loans. These banks of deposit started as early as the 1200s with Alexander the Great in Damascus and Barcelona in the 1400s. The true start of banking as we know it today started in Venice in the late 1300s.
The banks loan you this money so you can buy things you may not have cash for. The two types of debt are installment loans and variable-rate loans. Installment loans are normally your mortgages, student loans, and car loans. Variable-rate loans are normally your credit cards, adjustable-rate mortgages, and student loans. Installment loans have a fixed rate and the interest is “front-loaded” into the loan, so the bank gets its money sooner. This process is called amortization. The amount of interest you pay upfront can be shocking to first-time home buyers. I’m well read on the banking process and personal finances, and the mortgage process still shocks me. Before buying your first home, Google an amortization calculator and see how little your mortgage actually goes to paying down principal for the first 5-10 years.
Variable-rate loans are assessed a monthly interest rate based off the current interest rates, and a minimum payment is required. Your authorized credit is based off your income and credit score. Depending on the type of loan, your interest may be front loaded or evenly split through the life of the loan.
Valueless instruments are given to another person for an exchange of goods that are valueless themselves. Instead of exchanging goods like food for leather, a patron can give a seller something that is inherently valueless that represents value. There is a long history of these exchanges going back to the prehistoric days where Mesopotamians used clay tablets to conduct trade. Then coins were produced in the Roman times. Credit coins and charge plats were used in the 1800s and then finally credit cards in the 1950s.
This is a very quick overview on the origins of banking and issuing debt. We’ll dedicate several chapters on the banking industry once we’re done discussing most of the major expenses people typically have. The key takeaway is, in the current banking system, we use fractional banking which allows a bank to loan out money above and beyond what it has in deposit reserves. To keep deposits, banks pay interest to keep your money in the bank so they can loan out more money. There is typically a large spread between the low amount banks pay in interest for deposits and the high amount banks charge in interest for loans. This is called the net interest rate spread—the spread is never in your favor and is always in the bank’s favor.
SO WHY IS DEBT SO BAD?
Like mentioned above, being in debt exposes you to many risks. The most common risk, and the one I’m most concerned with in the immediate future, is interest rate risk. This is where rising interest rates limit your access to housing, cars, and possibly student loans. This is also a concern for the people spending 100% of their paycheck at current interest rates—barely making it to the next paycheck and only making minimum payments. If the interest rates rise, the minimum payments will increase as well.
Higher interest rates can make the cost of homes and cars go up drastically. The U.S.’ long-term interest rate hit an all-time high in 1981 and then went down to nearly zero from 2008-2015. The U.S. was even remotely considering a Negative Interest Rate Policy (NIRP) where we’re charged to keep our money in the bank. This is because our entire U.S. economy is dependent on people getting loans and immediately consuming things. For us to get out of a recession our only hope was excessive consumerism and debt. In 2016, interest rates started to increase. Banks immediately changed their loans and interest rates to continuously keep the net interest rate spread in their favor. So, the first reason why debt is so bad is because you’re exposed to interest rate risk, mainly with variable-rate loans. Depending on the interest-rate environment, fixed loans can protect you from the risk of rising interest rates. In the picture below, we see how rising interest rates increase your payments and can reduce the money you have available for other expenses and savings.
Another reason why debt is so bad is because you become dependent to the “system” of debt. Once we get into debt, we must work and/or earn an income. It’s the same philosophy behind taxes. Once you venture out on your own, you must work and/or earn an income and pay taxes. To become financially independent, you must make the money you save and earn make money itself from retirement plans, interest, dividends, and side job. So we get a job and our income becomes our means. We then voluntarily decide how we live from there.
Some live below our means, where our expenses are lower than our income and we save the discretionary income. We become financially independent earlier than the “system” recommends. Some live within in our means where our expenses (to include AT LEAST 10% savings) is exactly our income. We become part of the system and retire when it allows us to. Unfortunately, many people live above their means and rely heavily on loans and credit cards. For example, in the housing chapter we discussed that all housing expenses, to include your mortgage or rent, should not exceed 30% of your income. Below your means is well below 30%, within your means is 30%, and above your means is above 30%. If you’re living within or above your means and something happens to your job, then you’re at risk of financial ruin.
Your job is always at risk no matter what industry you’re in and being in debt exposes you to this risk greatly. To reduce costs, many companies outsource or automate operations. Industries are always at risk to new technologies that can make entire industries disappear. The economy can change and we can experience high unemployment. There are hundreds of risks to any job in any industry. If you live exactly within your means or above your means, then you’ll continually need to maintain those means.
And this is exactly why debt is so bad. If you use debt incorrectly, like many people do, you basically become a battery to the system and can’t unplug. Many of us accept this fate—but what if you hate your current job or what if an emergency in your life happens? To clarify, mortgages and student loans can be considered an investment. Wealthy people use debt as a tool, and when used wisely, can magnify your returns. Mortgages within your means, or rental properties, can give us equity, and passive income, as time goes on and higher education can yield higher paychecks, better benefits, and more stable employment. Home buying and choosing which degree (and its resulting debt) are lifestyle choices we can choose to make.
People who become debt free often claim that a weight has been lifted off their shoulders. People who are in debt often claim to feel a heavy burden or, as I mentioned above, like a noose is around their necks which is slowly tightening. The entire system benefits creditors, and fractional-reserve banking can create massive corruption and disruptions. Being debt free allows you to unplug from the system (except for taxes). As we discuss other expenses, know that increased debt payments, whether by higher interest rates or disruption to your income, can eat into your voluntary expenses such as entertainment, travel, and short- and long-term goals.