Monday, August 15, 2011
Undeniable Truths of Money #1: Debt is the Antithesis of Wealth
By borrowing money, you go into debt and as such you are pledging your future productivity to extinguishing that debt. This debt almost always carries interest, which is an additional claim against your productivity. As long as you owe your lenders, you are not free to put your excess productivity to the endeavors of your choosing - you owe it to someone else.
Let's presume Jennifer Munn and Jason Dane are the proud owners of the Widgetmaster 4000, which produces $5000 of highly marketable widgets per month. They own this glorious machine free-and-clear. It's all theirs and everything that comes out of it is all theirs to sell.
That's wealth - the ability to produce income.
Life is good. The Munn-Danes sit back and watch their Widgetmaster 4000 pump out $5000 worth of widgets per month. The UPS man comes and picks up the widgets, carries them to the four corners of the earth, and their Paypal account grows and grows. They buy the groceries, pay the bills and live a good life in their mortgage-free three bedroom rambler and fully paid F-150.
They get some new neighbors from West Seattle, Joe Hippen and Mary Trendy, who are really living large in their contemporary Northwestern Bainbridgeislanddreamhome on Rolling Bay. They have annual trips to Paris and London, Sounders FC season tickets, and constant dinner parties entertaining the parade of drug addicts disguised as friends they met at the latest Burning Man extravaganza. Swathmore and Marist brag stickers adorn the rear windows of their His/Hers Escalades as they drive off to their jobs as government equal opportunity lawyers.
It would appear that the Hippen-Trendys are very wealthy. Why not? They are certainly flaunting their "wealth," and their jobs as lawyers for Uncle Sugar probably pay pretty well - $200,000 per year, which certainly dwarfs the owner/operator of the Widgetmaster 4000's $60,000 per year.
It turns out that many people have a claim to a chunk of the Hippen-Trendy's income. The mortgage on that $1.1 million home runs $64,500, the leases on the Escalades run $24,000, college debt runs $48,000, and their ancillary spending is financed by signature loans and credit cards that run $17,000 for a 10 year payment plan, but they only pay half that. That $200 grand gets cut down to $55,000, and that is before the IRS gets their cut.
The Hippen-Trendys have only one "asset" as we would define it, and that is the sheepskin that enabled them to get civil service lawyer jobs, for which they give back almost 1/4 of the dividend. The house is underwater, the Escalades are zeroes, and the revolving credit has nothing they can use to sell off - it was all consumed.
The Munn-Danes have a higher net income than the Hippen-Trendys because they own themselves. The Hippen-Trendys have to work until early October before they have paid off the bankers, which is another way of saying the bankers own their entire production from January through Columbus Day. The Munn-Danes own themselves before the New Years Eve hangover wears off (IRS issues not withstanding).
We can also see how this works with net savings and debt. All of us can agree that a cash account of $500,000 would be an asset and would qualify its owner as wealthy. Let's presume this account is invested in various bonds that pay 6% interest. The income stream is $30,000 per year. On the other side of the ledger, the borrower (Ace Novelty Company of Walla Walla) is carrying a $500,000 debt which is costing them $30,000 per year. One is the antithesis of the other. One has wealth, the other has debt.
In the case of Ace Novelty Company, they are using the $500,000 to build a rubber dog squeeze factory in Hong Kong, where they show they will be able to produce $50,000 worth of rubber dog squeeze per year, which is flown by cargo plane back to the United States. After they pay back the $30,000 plus principal to the bond holder, they still end up with a profit, and after the debt is paid back, they will have an unencumbered asset and full claim to its production.
Debt isn't necessarily bad, it just precludes you from owning yourself. If you don't own yourself, someone else does, and bad things descend from that reality.