A Secret to Debt Elimination and Building Wealth
July 31, 2019 |William Hancock, CDEP
Debt in America is reaching all-time highs. It’s all over the media. It’s impacting the economy, individuals, families and even small businesses. Even college graduates are realizing the long-term impact of loans they took out the previous four-plus years.
One solution is actually a simple concept that has been around for over a century. The secret is to “manage your money like a bank”:
Cash vs Financing –
There are two types of consumers, whether we’re talking about how individuals and families buy things, or how businesses buy things:
Cash purchasers build up a balance of cash through savings and sacrifice, then make their purchase with that cash. When they do – their cash balance is depleted (taking them down to what we call the “0” line). Then they slowly rebuild their cash reserves to the point they can make the next purchase – taking them back to zero line again. They repeat this pattern throughout their life believing that being a cash purchaser and avoiding debt is the best way to manage their finances.
Financed purchasers buy something on credit – they go into the red and owe the money that was lent to them to make that purchase. They make payments over time, and end up back at the zero line, where they have no debt but they don’t have any cash.
Both the cash purchaser and the financed purchaser end up with a paid-for asset and both always end up at the same place from a cash point of view – the zero line.
The reality is that we finance everything! Cash purchasers don’t go into debt, but buy by sending their cash off to the seller of whatever it is they bought. Then they no longer have any cash. Because they don’t have cash, they will never realize any interest or growth, which is critical for their long-term financial success.
Those who buy things through financing of course pay someone else for the use of their money over and above the cost of the item purchased.
The cash purchaser incurs an “opportunity cost” (they give up the opportunity for their money to grow and to compound). The financed purchaser incurs an “interest cost”. Both costs are very real and both are very expensive.
This is how most of us live our lives and manage our finances. We may even mix the two from time to time. Buying with cash when we can and financing other purchase when we must or want to.
But there’s a secret about money that banks know, that most of us as individual or small business consumers don’t know. The secret is that on the same amount of money, using the same interest rate, over the same period of time, there is a significant difference between the opportunity cost given up by the cash purchaser and the interest cost incurred by the financed purchaser.
Leveraging that difference is how financial institutions make their money and they all seem to be doing pretty well, don’t they?
Banking Business Model
The “business” that they’re in is pretty simple when you think about it. You and I make deposits into our bank accounts and often they may pay us an interest rate on our deposits (after all we are in essence lending them money). Let’s assume for discussion purposes, that the bank pays us an interest rate of 1%.
The bank is going to turn around and lend that money out to a borrower. Let’s say they do so at a rate of 6%.
When we buy something for a dollar, then sell it for $6 dollars, don’t we earn a profit of some 500%. Isn’t that what the bank is making?
If that is the case, the question is: Who do you want to be in the equation? The depositor- earning 1% (or less). The borrower- who’s paying 6% (or more) for the use of your money? Or the Banker who’s making a 500% profit in between?
The answer is obvious. But what choice do we have? We can’t all go out and start our own bank, can we?
Well, yes, we can. Each one us can start our own family bank. If we are a small business owner, we can start our own business bank. And when we do, when we learn to make money work the way banks make money work, the results can be life changing.
To see just what we mean, let’s consider the following example. Let’s say you have $5,000 in cash and you need to make a purchase of $50,000. It doesn’t matter what the purchase is. It could be something personal or it could be something your business needs. It could be a product or a service.
Whatever it is, you have a choice. You can pay cash for it or you can finance it.
So, let’s see what the best way to make this purchase is based on what we know about how banks make money. Remember, we said there was a difference between opportunity cost and interest cost? You’re about to see that difference and how you can capture the benefit.
If we hold on to our $50,000 and invest it at 5% over 5 years, we will end up with $63,814 for a gain of $13,814. That is compound interest. What Einstein called the 9th wonder of the world.
To make the purchase, let’s borrow the $50,000 instead, and let’s do so at the exact same interest rate, 5%, for same 5-year period. Our payment would be $944/month X 60 months, meaning we would repay a total of $56, 614 and incur an interest expense of $6,614. That is called amortizing interest and it is exactly how any lender anywhere would set up the payment schedule.
Now for the magic. If I could hold onto my cash and not incur the opportunity cost so that my money grows by $13,814 and instead incur the interest expense to finance my purchase, $6,614, don’t I get to keep the $7,200 in between?
And if I do, I have figured out a way to “play banking”. I have essentially made my money do two jobs at the same time. I have taught it to grow for me by saving and investing it and at the same time I have used it (or the fact that it exists) to fund a purchase I needed or wanted.
When we live our lives that way and we manage our finances that way, then over a lifetime, two important things happen.
From a lifestyle perspective, we have everything either the cash purchaser or the financed purchaser has. But unlike the straight cash buyer, or the straight financed buyer, we capture the difference between the two types of interest, the compound interest and amortized interest and we build wealth. We never end up at the zero line.
This is how banks make money. This is how businesses like GM make money. They make money selling vehicles, and they make money financing vehicles. This is how you can make money, whether you are an individual, a family or a business owner.
It is not complicated. It is not expensive. It is not out of reach. All you need is the will to convert interest expense into wealth.
Start “being you own bank” and capture the ‘spread in between’.