Role of Credit

The role of credit in the economy is to allow a company to purchase assets that will provide a return in excess of the cost of credit.  So you would use credit to purchase either inventory that you could make into a part or a machine to make more parts in a shorter amount of time.  The company’s assumption is the sale from these parts would generate a profit that would be more than the interest cost from the debt.  In other words credit is used to make more money.

Almost all businesses have calculations and analysis they do before purchasing a capital asset and they factor their cost of capital into that analysis.  Using the same criteria, what reasons are there for using credit in our personal life?

The mortgage first comes to mind.  First our cost of borrowing is our interest rate which currently on a 30 year mortgage is approximately 5%.  You also get a tax break on your mortgage.  Assuming you are in the 25% income tax bracket, this would reduce your after tax cost of capital to 3.75%.  So effectively if you decide to purchase a house right now you must assume that your after tax annual rate of return will be greater than 3.75% to be an effective use of debt.  The average home price appreciates at the rate of inflation which has been between 3%-5% over the last 20 years and even higher than that during some periods.

You may decide to save your money and pay cash for a house.  The only problem with that is you have a rent payment for a place to live while you set money aside for a house.  You have two options rent a house similar to what you could afford and see if the rent is cheaper than the payment you would have on a mortgage.  If the payment is the same then you are better off (if you have saved enough for the down payment) purchasing the house because the payment each month is earning you equity in addition to your expectation of the asset price increasing.  So a mortgage is a legitimate reason for personal debt.

What about a loan for education or a higher degree?  Well again that would depend upon your cost of capital.  If you take out a loan for college, which normally you do not have to pay back until you graduate, lets assume the interest rate is 6%.  This is also a tax advantaged loan.  So assuming the same 25% tax bracket your after tax effective rate is 4.5%.  The average college graduate will make $19,000 more per year than the average high school graduate according to a report by The College Board.  Most state schools in state tuition are between $3,000 to $6,000 per semester.  So your degree could pay for itself in two years with the additional income you could earn with a degree.  This is also a legitimate reason for personal debt.

An auto loan carries and average rate of 7.5% unless your credit is good enough to get a 0% rate from the manufacturer.  However, there is one flaw in the car loan that no one ever talks about which is that an auto is a depreciating asset, so you will ever earn a return higher than your cost of capital on an automobile.  You are much better off saving enough money to purchase a used car for cash and then continue to save what you would be making on a car payment each month until you can afford to purchase a newer car.  An auto loan is not a legitimate reason for personal debt.

Now last but not least.  Credit cards, which are unsecured debt.  The average credit card rate is 10% to 12% with good credit.  There are very few ways to earn a return in excess of 10%.  Worse still is that most credit card debit are consumption purchases which are items that are consumed and no future return can be obtained.  Debt financed on a credit card for consumables is not a legitimate reason for personal debt.

There are cash back and rewards cards that offer you cash or reward points for using them like the Discover® More Card , Chase Freedom card, and others.  There can be a wise case for using a credit card to make purchases that you have the funds for in a savings account that you can pay off by the next due date such as your car insurance.  I purchase my car insurance by paying six months of premium using a reward card.  I pay a 5% reduced rate on my auto insurance for paying six months of premium up front, I receive rewards of 5% of purchases and my money sits in my savings account for 30 days after the purchase.  So I am earning approximately 10% through discounts and rewards for purchasing auto insurance which by law I have to purchase.

Review any debt you have outstanding and if you have any debt that does not make economic sense please come up with a plan to pay it off.  These small steps can make a difference in your finances.