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| The Basics | Knowing when to borrow -- and why
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Borrowing has a bigger impact on your wealth than almost any other decision you make. So what's a good reason to borrow? To buy a house, sure, but not much else.
By Mary Rowland
The decisions about when and why to borrow have a bigger impact on your overall wealth than almost any other decision you make. Yet few of us think about it in those grand terms. Instead, we think of solving an immediate problem or fulfilling an immediate need -- or desire.
Check the MSN Money newsgroups on any particular day and you're likely to find questions like these: Should I borrow from my 401(k) to buy a home? Should I take a cash advance on my credit card to start a business?
Thinking in this piecemeal way about your finances can be devastating to your wealth. It's like shooting yourself in the foot before you run a race. By borrowing money and paying interest, youre decreasing your overall wealth to accomplish a goal or acquire an asset. If what you acquire is a wasting asset -- something that declines in value -- you put yourself further behind in the game of realizing long-term goals.
There is a debate going on in Academe right now about whether people make financial decisions in a rational way. Economics is based on a theory called the utility theory, which assumes that each person's goal is to maximize his wealth. To do that, the rational person examines each financial decision to see how it will impact his wealth over the long term and then makes the choice that will increase his wealth.
Of course, that's the way it should be. But it's a long shot from the way it is. "Every one of these assumptions is wrong," says Daniel Kahneman, a psychology professor at Princeton University and a leading figure in a new discipline called behavioral finance. "People take a short-term view and they compartmentalize things rather than looking at them in a grand way."
Behaviorists like Kahneman argue that we think in terms of mental accounts. For example, we mentally put our 401(k) plan into one account and consider whether that account is ahead or behind for the year. Our home is another account. Emergencies, and loans, are another matter altogether.
This kind of thinking is destructive to your wealth. One way to correct it is to use a software program such as Quicken or Money 2004. These programs look at your total financial picture and your overall wealth. If you take out a loan and pay interest, that money has to come from somewhere. Your retirement account? Your vacation account? You can see immediately the blow you inflict on your overall wealth by borrowing.
Borrowing should be saved for rare occasions
Of course, there are times when you must borrow. But they are probably fewer than you think. You should never borrow for a wasting asset. That includes clothes, furnishings, entertainment, vacations and dinners out.
"If you pay only the minimum balance on your cards, you could be paying for that dinner 30 years after you digested it," says Marc Eisenson, author of the best-seller, "The Banker's Secret," and a staunch opponent of any kind of debt.
Most credit cards require a minimum payment of 2% to 3% of the balance, Eisenson says. That means youre required to pay only $100 to $150 a month on a balance of $5,000. "Most people assume you are better off with the one that requires $100," Eisenson says. "But with that one, you are paying so little in principal that you could be paying for 30 years and end up sending in $10,000 to $15,000 in interest for the $5,000 you borrowed.
Likewise, a $100 dinner could cost you $300 by the time you've paid it off. But the after-tax cost is much higher. "People forget they have to earn a lot more because they have to pay taxes," Eisenson says. "So you really have to earn $450 to have $300 left over for that meal. That's why so many people are caught living paycheck to paycheck."
What is a good reason to borrow then? Perhaps the best reason is to buy a home. A home mortgage is one of the few loans that still provides a tax deduction for interest. That makes the real cost of a home mortgage less than that for other debt.
All interest you pay on a home of up to $1 million in value is tax-deductible. So if youre in the 30% marginal tax bracket, the government pays 30% of your interest. That means if you pay $15,000 a year in mortgage interest, the real cost to you is just $10,500.
Looking at it another way, if you pay 8% on your loan, the after-tax cost is 70% of that, or a 5.6% interest rate. You might also build in an inflation factor. Inflation is a great boon to debtors because they acquire an asset in today's dollars and pay it off in tomorrow's.
Even with the low inflation we have today, you could reduce your real interest rate for a home loan. If inflation is 2%, perhaps we could say your real cost of borrowing for your home is 5.6% minus 2 percentage points or 3.6%. Taking inflation directly off the interest rate is hardly a mathematically rigorous method of measuring your cost. Ideally, you would look at cash flows and so forth. But it gives you an idea of what it costs you to borrow.
Owning your own home provides psychological as well as financial benefits. That's why many financial planners like MSN Money columnist Ginger Applegarth urge clients to "go for it" when they find a home they love.
The ideal consumer, I think, would take out a loan only for a home -- and perhaps a second home -- to capture the tax break. Everything else would come from his emergency fund or from short-term or long-term savings.
So our model consumer sets short-term and long-term goals, sets aside money to realize them and, in fact, operates under the utility theory that many economists have abandoned to increase his overall wealth. If you fall short of the model, aim for it.
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MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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