Mar 03, 2020

Debt and Wealth Accumulation

There is an array of information regarding the use of debt when it comes to financial planning. Most of the articles are geared toward debt management, debt repayment and using debt to obtain assets currently out of reach. While each of these topics are important and worth investigating, I want to focus on how debt, specifically unnecessary debt, can profoundly impact wealth accumulation.

 

When it comes to debt, we first need to rationally categorize it’s uses. There are some in the debt management landscape who regard any and all debt as bad. They do not condone the use of credit cards, car payments or even mortgages. This camp is, and is intended to be, extreme. It really is meant to draw our attention to how damaging debt can be, but most people find this approach unpracticable. On the other side of the spectrum you find people who willfully finance any and all purchases, frivolous as they may be, with debt. They can recite the pros and cons of credit card reward features and they always seem have nice things. This is not an appropriate use of debt.

 

I like to view debt through a simple binary. Is the debt necessary or unnecessary? Of course, we could get into the weeds and have lengthy discussion about what constitutes “necessary” and to whom and to what situations exceptions should apply, but it would be outside the purview of the basic message. We all know when we are buying something we need and buying something we want.

 

Necessary debts take different forms, but there are a few that stand out. For some, student loans will be a necessary piece of their financial picture in order to launch a lucrative career. Most people, at some point in time, will take out a mortgage. This debt is widely regarded as “good debt” and I would consider this necessary.

 

Debt that is not taken for higher education or for the acquisition of a home tends to fall under the broad category of “consumer debt”. This debt is more nuanced. Some people will enter a line of work, live in a city or have some other legitimate reason to have their own vehicle. This, in many cases, will require some debt financing. Others will have situations arise where consumer debt is necessary, but this is rare.

 

This is the heart of the issue. Taking on consumer debt that we think, or wish to think, blurs the line between necessary and unnecessary. As human beings who like nice things, we have the innate ability to justify buying just about anything. This explains the inextricable link between income and expense. We pretty much spend whatever we make. When you hear “I got a promotion, so I am making more money now” what this means, eventually, is “I got a promotion so I am spending more money now”.

 

It is evident, even to the untrained eye, how this could have a profound impact on wealth accumulation. To simplify the ramifications, we can use a simple example

 

Fred has decided he needs to “upgrade” his vehicle and decides to buy a new car. This requires a down payment, which he has in cash and a $500 car note, interest included, to be paid monthly for the next five years. The math in this case is simple, we can do some quick arithmetic and find, all in, Fred will pay $30,000 over the course of the next five years. For the sake of simplicity, we will assume Fred made a down payment of $10,000.

 

At the end of five years Fred will have invested $40,000 in this car, some of which will be in the form of interest paid on the loan, but all of which will come from Fred’s pocket and go toward a depreciating asset. The cost of this appears to be $40,000. But let’s examine the opportunity cost of such a transaction.

 

Assuming the same fact pattern as above we can assume Fed has $10,000 in cash and the ability to spend an additional $500 a month. Instead of upgrading his vehicle Fred decides to place the $10,000 in a growth oriented mutual fund and make $500 monthly additions. We will assume a growth rate of 6% compounded annually for this example.

 

Number of Periods (N) 60 (5 years x 12 months)

Initial investment $10,000.00

Interest rate .5%. (6%/12 to get monthly equivalent)

Periodic deposits (PMT) at the end of each month: $500.00

 

The results: $48,373.52.

 

This isn’t a life changing amount of money, but a survey by Insider and the Morning Consult found that while 70% of millennials do indeed have a “savings account” 58% have a balance under $5,000. This is not to say that all of those who have low balances have purchased vehicles or have used other unnecessary consumer debt to “improve” their lifestyle, but many of them have. This is to demonstrate how profound an impact this can have on future wealth. The upgraded vehicle feels like $500 a month, but it is forgoing nearly $50,000 in future savings.

 

This example simply examines the numbers, but this doesn’t address another pressing matter when it comes to debt; your wellbeing. In an article written by Kristen Kuchar titled “The Emotional Effects of Debt” she details, from various sources, the effects debt can have on our emotional health. She narrowed these into subtopics

Depression and Anxiety, Resentment, Denial, Stress, Anger and Frustration, Regret, Shame and Embarrassment, and Fear. These are feelings we are far better off staying away from. Not to mention large doses of these can lead to, as Kristen points out, clinical depression and anxiety, divorce, debt forming habits and chronic stress.

 

If you take on consumer debt you are not guaranteed crippling despair and depression, but you are forgoing more savings than you may think. Dollar cost averaging is a fancy phrase financial advisors (I know a few of them) throw around, but all it really means is investing the same amount of money on a fixed schedule. This is as simple a technique you can find, but it is incredibly effective.

 

If we looked at dollar cost averaging the same way we look at making our “necessary” car payment or credit card payment we would all be better off. Unnecessary debt can present a huge hurdle to wealth accumulation. If you can replace that with simple, sound investing habits, you will be far better off in the future.

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