Monday, February 19, 2007

Can debt be good?

The classic answer to any finance question is always, "It depends."

Consider Chief Clancy Wiggum (PS - I love the Simpsons). Clancy probably makes about $55,000 a year, plus the fringe benefits of all-you-can-stuff donuts and coffee. He's faced with a tough decision: He wants to join a gym, but gym membership costs $200 / month, and he'll need to pay for 12-months up front.

He can: A) Save up $2,400 and pay it in cash, B) Put it on his credit card with a high-interest rate, or C) Find some mix of A and B.

If he goes with A, it can take quite a while before he gets that much money, and in the meantime, he may end up spending that money for other things.

If he goes with B, he runs the risk of maxing out his credit for what isn't necessarily essential, and paying high-interest rates.

If he goes with C, there is a lot of headache time, as he figures out what he can do. But, it gives him time to weigh (no pun intended) how much time he is willing to wait before getting the membership and how much the credit cards will charge.

But, Clancy may even have a plan D. Say Homer Simpson finally comes up with his killer invention that will make the family millions, but he needs a small loan to get it going. Homer goes to Clancy and says, "Hey, I'll pay you 20% APR for $2,400" If Clancy has a good credit rating, his credit card APR will probably be about 16-18%. Now Clancy can loan the money, go to the gym, and still make money off the 2-4% APR difference!

It's called making your money work for you. On a side note, I once interviewed with a wealth management division of a major bank. In our discussion, we talked about how much money it would take to before the bank will do business with you. Their lowest rank started at $100K cash.

I mention this because many of these rich folks have their money fully invested in the bank, and actually take out loans to pay for items such as cars and homes. Many times, these people are making 10% returns on their money. When they need money, the bank loans it to them for about 7%, so the customer is still making a 3% return on the money he spends (the difference between what he has invested and what he borrows)!

To answer my initial question: Debt can be both good and bad. Having a little is always good; having too much is always bad. Being debt-free is worry-free, but you're not putting your money to work.

1 comment:

Wanda said...

hey.. welcome to the pf blogosphere. it's always great to read about other twentysomethings... especially ones who live in nyc!

good luck with your goals.