Caution about Borrowing Money

In an earlier post, Why Credit Scores Should Be Ignored, I argue that credit scores are unimportant and that they encourage people to do things that benefit banks at the expense of consumers. I also suggest most borrowing by individuals is a bad idea. Most readers will agree that credit can be misused, but what about responsible use of credit? Isn't it a benefit to responsible borrowers to have a credit report containing things banks like to see?

Responsible Credit – The Math

The idea of responsible credit is to borrow money for activities that return more than the cost of interest. A worthwhile business ought to return more than the cost of borrowing money. Therefore, the reasoning goes, if you believe in your investments and businesses, you ought to borrow the most you can to fund them.

In the most common scenario, individuals borrow money on their homes and invest it. They hope to make 12% (8% after taxes) on it. The loan on their home is 6% (4% after home mortgage deduction). So they're borrowing at 4% and making 8%. This seems like a no-brainer.

But they should ask where that borrowed money's coming from. It's coming from people making deposits at an even lower rate. Why are depositors accepting a lower rate instead of investing in what you're investing in? Maybe it's because they're unsophisticated or very risk averse. Then why are the financial experts at the bank lending the money to you instead of investing at higher rates? It all comes down to risk. There is some risk in a portfolio that provides higher returns. Individuals borrowing from the bank to invest (or keeping investments while they're making payments on a home loan) need to be aware that they have chosen to accept risk in exchange for more money. There's nothing wrong with doing that. But they should not be surprised if at some point in their life they have to make quick changes when their portfolio goes down at the same time they lose their job.

A similar argument applies to business debt. If the businesses does not work, the borrowers will have to sell whatever they must to repay the debt.

Consumer debt is the worst because it's used to buy things that are not expected to return any money. Oddly though, the line of reasoning that leads people into mortgage debt and business debt can be used to rationalize consumer debt. People think their investments or business are so good that they should maximize all borrowing so they can maintain their consumption while investing all possible money. Even if their investments do return more than the cost of the debt, there is a hidden cost of consumer debt: It makes it very difficult to track income vs. expenses. Having all this money flying around to and from loans complicates basic budgeting. It also makes people vulnerable to liquidity problems if there are unforeseen expenses or income interruptions.

Should We Never Borrow Money?

Everyone needs to look at the risk and answer the question for himself. IMHO, if people do not have the money to buy a house but could borrow the money at roughly the same payment as renting the space, they should do it. They are taking the risk of a problem with the home or a decline in prices, but they get the benefit of the potential profits their landlord would have made.

If someone with no money needs tools or a vehicle to get a job, borrowing money could make sense for them. IMHO, they should explore all other avenues, e.g. a job that provides tools and does not require a vehicle.

Caution

The point of this post is to urge caution. Many people borrow money on cars assuming that their income will remain steady. They borrow money on houses without even considering that they could lose money. Even people with jobs that they know are unstable continue to ignore the reality. When one of life's hiccups eventually occurs, they are shocked. After the fact they call on politicians to subsidize their mortgages or to try to bring back post-WWII era job security. I am not commenting here on whether politicians should do those things. I'm simply saying that until they do, intelligent people should see the risks of the financial products they buy and take caution.

When a salesmaker approaches people on a car lot, they are rightly cautious. They may preface questions with, "I'm just browsing." They know that the salesperson may want to sell them products that are not right for them. They know they need an independent opinion.

In the case of financial products, however, much education comes from financial institutions themselves. They teach people to "protect their credit score". They produce educational materials for children explaining why financial products are part of the path to responsible adulthood. They train so-called "financial planners" to sell financial products to people who are seeking financial advice. Most of the financial education the average person comes across is aimed at benefiting financial institutions, not consumers.

Many financial products are worthwhile. It's important to take the time go over each of them, as we would with any purchase, and ask if we really need them and if we're getting a fair deal.

Caveat emptor.