In economics, it helps to ask the questions, “What is really going on? What is the heart of what we are discussing?”. It surprises me that things most familiar are most often taken for granted and, in many cases, not understood very well. By reframing things through that lens, decisions often become clearer.
Consider the relationship between saving money and borrowing money. I’ve been helping some friends and family members lately go over their personal finances so the nature of saving and debt has been on my mind. It doesn’t matter if you have a home mortgage, student loan debt, credit card debt, a line of credit, or a bill you owe a vendor. People talk all the time about how they need to get out of debt or refinance a particular loan. What is really going on? What does it actually mean?
Here is the way I look at it. At its core, when you borrow money, you are renting someone else’s savings. It doesn’t matter if you borrow money from a bank, borrow money from a family member, or borrow money from an online group such as Lending Club. Someone, somewhere had to spend less money than they earned, generate a surplus, and then put that money aside in reserves. Often, the saver parks it in a checking or savings account. Less often, they shove it under their mattress.
When you find yourself in a situation where you need to write checks, but don’t have enough money to make sure they clear, you need to approach a saver and ask to rent their savings. To compensate the saver for the time he or she can’t enjoy the own money, and the risk you might not return the property in whole, he or she requires that you pay an on-going charge based on your risk profile, credit history, and the length of time you need their cash. The “rent” you pay is called interest expense, but it is exactly the same economic reality as if you rented an apartment or a lake house.
In the case of a bank loan, such as credit card debt or student loans, this is still true. The difference is a financial institution is working as an intermediary, matching up the savers (the depositors) and the borrowers (the people who need to rent someone else’s savings), taking a cut for the overhead of branches, technology, and most important, skilled bankers who specialize in evaluating risk.
[mainbodyad]For all its flaws, the banking system is really a case of specialization. Most folks don’t want to spend their evenings looking over loan applications and trying to track down past due borrowers. The banking system allows that fate to be avoided. Savers deposit their money; the bank lends it, and the result is often shared in some form or another between the saver and the banking institution. For those who want the bank to take no cut at all, the best option might be a community credit union that distributes its share of the earnings to the savers (depositors) based on their total account value or some other set of criteria.
Though it isn’t perfect, it is a brilliant system. The saver gets rewarded for putting off the enjoyment he or she could have earned by spending the money themselves. Instead of taking a vacation or buying a new car, they build storage units. Now, your town has facilities that provide value to other people. You need the use of the storage units so you pay for the right to temporarily enjoy the facilities. Thus, individuals, and individual families, are able to decide what they would rather have and pursue their own happiness.
This capital formation is the reason that the United States thrived, while communist Russia collapsed. You need to have individual people, motivated by their own opportunity cost, who are willing to forgo the enjoyment of their savings today for the chance of future income. That does result in inequality because not all choices are equal when it comes to creating or spending financial wealth, but overall, it increases standards of living. The way we live now, which was largely created by this system, is so far beyond anything our ancestors could have imagined that it borders on the unfathomable.
Anyway, back to the point. Sometimes, renting savings from other people can be beneficial, even if you have plenty of savings and investments yourself. During my college years, the United States Government offered to rent the taxpayers’ savings to college students for 20 to 30 years at an annual rate of only 2% to 5%. I signed up for it because I already had capital built up that would allow me to repay the loans instantly, and I knew historical inflation ran 4% per annum between 1900 and 2000. Backing out inflation, the true cost of renting savings from the taxpayers ranged from a negative cost to barely around 1%. Even then, I would recommend striving to be completely, totally, and utterly debt-free. Short of a medical catastrophe or liability issue, it is virtually impossible to go bankrupt if you have no debt. The only reason I was willing to take on the promise of repaying other peoples’ savings was because the burden was small relative to my income earning capacity and asset reserves.
[mainbodyad]A few of you may be saying, “So what?” and you’d be right. It seems like common sense, but common sense isn’t common. If high school students or even adults were taught to think of borrowed money as renting someone else’s savings, they might be less likely to take on debt. The world, overall, would be a better place. Leverage has destroyed a lot of people. The best place to start is in understanding the system with which you are dealing or in which you are operating.
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