If this was the official definition of debt it would then be obvious to people that by using debt you are likely getting less now than you could have had later in exchange for taking instant gratification today. This therefore affects your opportunity to create wealth. I do not believe that the majority of people appreciate this when they go into debt to buy something. My definition also tells you this is for 2 reasons:
1. Interest charges. Buy it now without the means to pay for it up front and the end result is that each loan repayment being made to repay the debt is going to include a principle portion, which will eventually cover the original purchase price, plus an interest charge. If you instead chose to save what would have been the regular repayment amount until you have saved up enough to pay cash then two phenomenon occur:
- You will save the amount needed for the purchase faster than the equivalent loan will be repaid because what would have been the interest portion is adding to your savings.
- If you saved until what would have been the last loan repayment day then you will end up with more cash than the original purchase price, again because of the interest portion.
It’s important to note that these statements are based on the assumption that the purchase does not rise in price at a rate higher than the interest charge. If this was the case then you would also have to include the opportunity cost (including considering the risk of that other opportunity) of deploying the debt repayment s elsewhere. If after this calculation the price was still rising at a faster rate then the debt may actually help with wealth creation while also giving instant gratification.
Let’s use a simple example to demonstrate. Average Bob, Average Jane and Average Joe are all looking at a potential purchase. Let’s say they have seen a piece of Art that they like which costs £10,000. While looking nice this piece of Art is not expected to either increase or decrease in value. Note that by choosing an example where we see no decrease in value it represents the worst case for wealth creation. Had I chosen a car, a holiday or a new sofa as the example then the wealth creation opportunity is greater.
Average Bob decides to go for it and takes out a 5 year loan with an annual interest rate of 5% so he can get instant gratification. Average Jane decides she’ll save the equivalent to what Bob makes in repayments under the mattress and will buy an equivalent piece of Art in 5 years time. Average Joe decides to also defer the purchase for 5 years but he chooses to invest the money that would have been used to repay the loan into a FTSE All Share Tracker Fund, within an ISA, which over the 5 year period earns a 7.5% return per annum. To make the maths easy we’ll also assume the repayments, savings or investments are only made once a year at the end of the year.
The end result is (also detailed in the chart below):
- Bob has been making loan repayments of £2,309 per year for 5 years, has had great satisfaction looking at what he has bought every day and ends up with an asset and wealth of £10,000.
- Jane has been saving £2,309 per year under the mattress. She buys her Art after 5 years so also has an asset worth £10,000 but is also left with £1,548 of cash left over which makes here satisfied. Buy simply deferring the expenditure and hence not making the interest payments she has a net wealth which is 11.5% greater than Bob.
- Joe has been saving £2,309 per year into his ISA. He also buys his Art after 5 years so has an asset worth £10,000 but is also left with £3,415 in his ISA which makes him satisfied. By deferring the expenditure and hence not making the interest payments plus taking some risk by investing the money (the Opportunity Cost portion) Joe ends up with 34% more wealth than Bob.
Click to enlarge
Finally, one other point to note is that by first focusing on wealth building, then gratification I have found that I am in the position where for any purchase that I could now ever want to make, except for a home, I would no longer need a loan to support the purchase. Even the home mortgage I would still need is getting closer to not being required as I sit on the sidelines, renting humble accommodation, that is far below the standard of living that I could secure either through renting or a mortgage while saving the difference.
As always do your own research.