Borrowing vs. Saving

The question often comes up whether or not it is ever right to borrow money (use credit). The best way to answer this is to give you Scrooge rule number 1: borrow to purchase appreciating assets, save to purchase depreciating assets. If you follow this rule it will almost surely make you richer. Let’s look at this rule a little closer. Borrow to Purchase Appreciating Assets An asset is any property of value. It could be real estate, cash, investments, works of art, automobiles, computers, etc. Appreciation (the word comes from Latin and literally means to add price) is when something increases in value. So an appreciating asset is a piece of property of some sort that is increasing in value. By the very defi nition, if you invest in an appreciating asset it will increase in value. Therefore as long as the cost of borrowing – the interest rate – is lower than the appreciation potential of the asset, it makes sense to borrow to purchase an appreciating asset.

Here is an example of how this can work to your benefit. Let’s suppose you decide to borrow $100,000 to invest in a variety of blue chip stocks that have a track record of increasing at an annual rate of 12%. (If you think this is pie in the sky, just look at some of the dividend mutual funds that have given this return even over the last couple of dismal investment years.) The cost of borrowing the money is 5% and the payments are spread out over 25 years. At the end of the 25 years the loan will be paid off and the cost of borrowing (total interest paid on the loan) will be about $79,000. (And this is ignoring the income tax refunds that you will get because this is an investment expense, which will make the cost of borrowing even lower.) However, to your benefi t, the blue chip stocks that you bought will be valued at $1.5 million at the end of 25 years. A good piece of real estate might appreciate at the same rate. However not all assets appreciate in value. Over a number of years real estate, quality works of art and blue chip stocks will usually appreciate in value. However, new automobiles or computers almost instantly depreciate in value the moment you buy them. These are examples of depreciating assets. Save to Purchase Depreciating Assets Depreciating assets truly are another kettle of fi sh. By their definition they are assets that drop in value – like automobiles or computers. (There are, of course, some cases where a rare automobile, for example, may appreciate in value. Rare cases like this are excluded from this discussion because they are the exception not the rule.) Another example is cash. Cash is actually a depreciating asset because if it isn’t invested infl ation causes it to lose value. From a logical point of view, from an investment point of view and from an accounting point of view, it makes no sense borrow money to buy a depreciating asset. If you do, you will lose money. That’s because you must pay the interest on the loan, and the value of the asset drops so there is no opportunity to ever recoup your original cost. The only time it makes sense to borrow money (or use credit) to buy a depreciating asset is when it affects your income potential. A good example of this is when your employment depends on you having a car. In this case you are really buying the automobile to increase your income, and it becomes a cost of your employment. The best way to handle depreciating assets (ones that you don’t need to ensure employment) is to save for them. Suppose you are tired of your old sofa and want a new one. Don’t borrow money to buy one. Save money instead. When you have the amount saved up you can then go and buy it with cash. If you say you have to borrow because you could never save enough to buy it, then you shouldn’t even entertain the idea of buying it. The reason is when you borrow you will have to pay back the original cost plus interest. If you can’t afford it without the interest you sure won’t be able to afford it with the interest added. So this leads us to Scrooge rule number two: If you can’t afford it, don’t buy it. Live within your means.

Scrooge