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Question for the Money Doctors

Question submitted on Mar 5, 2012.

Question

when is it wise to borrow money and when is it not? what factors do you need to consider to help you make a reasonsible choice? discuss the concepts of decision making and opportunity cost in your anwser.

Answer

There are people in the United States today who have never taken out a loan, made a purchase on credit, or owned a credit card. They believe that if you can''t pay cash, you can''t afford it and shouldn''t buy it. One thing is certain: Bill collectors will never bother these people. What these people know is that you can get into financial difficulty if you borrow too much, too frequently. However, what these people seem to misunderstand is this: It is frequently beneficial or at least convenient, to make purchases using someone else's money. If you are thinking about borrowing money, and you are new to the world of credit, you should know about some of the benefits and dangers of borrowing.

 What are the benefits of borrowing money?

 Successful borrowing can help you create a positive credit history. A positive credit history is important for many reasons. Even if you do not believe in making purchases on credit, it is good to have the ability to do so. In the event of an emergency, it is good to have access to emergency funds. Unless you have adequate liquid savings, you will need to borrow money to handle an emergency. To do so, you will need a positive credit history.

Credit is also desirable when making major purchases. Saving up the money to buy a house may take many years, and you will have to pay rent while waiting. If you have a positive credit history, you can obtain a mortgage loan, buy the house, pay off the mortgage over 30 years, and live in the house while you're doing it.

If you wish to use credit to help yourself in these situations, then you must establish a good credit history You do so by borrowing. Only by borrowing, and paying off your loans as agreed, do you establish a good credit rating and make the easy acquisition of credit possible.

 Leverage can be used to increase the return on your investments. If you can borrow money, you can use leverage to increase the return on your investments. This is possible because you can own and control more property with less of your own money. The following illustrates how you can increase the return on your investment using leverage:

Example(s): Hal had $50,000 that he wanted to invest in real estate. He found a house that cost $150,000. He convinced Frank and Bob to invest $50,000 each in the same house. They purchased the house and each owned one-third. The value of the house increased to $180,000 and was sold. Frank, Hal, and Bob shared a $30,000 profit. Each realized a $10,000 gain, or a 20 percent return, on their investment.

Hal, being a thinking man, decided to invest in more real estate. However, this time he decided to use leverage to increase the return on his investment. He made a $50,000 down payment on a $150,000 house and took out a mortgage for $100,000. By borrowing in this manner, he was able to own and control the entire asset, rather than just one-third. When the house increased in value to $180,000, he sold it, paid off the mortgage, and realized a $30,000 gain, or a 60 percent return, on his investment.

The example is simplified and does not take into consideration taxes, interest, or rental income, but it illustrates the notion that by using leverage, you can control more assets using less of your own money.

Caution: The problem with leverage is that it can work both ways. Assume that the two parcels of real estate in the previous example dropped in value to $120,000. In the first transaction, Hal would have lost $10,000, for a 20 percent loss on his investment. In the leveraged transaction, Hal would have lost $30,000, for a 60 percent loss on his investment.

 Borrowing is a convenient way to make purchases

Without considering all the financial variables, borrowing is just plain convenient. Credit cards are the most convenient form of borrowing. You can buy your lunch, buy a movie ticket and popcorn, buy stamps at the post office, make a long-distance phone call from a pay phone, buy groceries, get gasoline, book a trip to Aruba, get your teeth cleaned at the dentist, and order a CD, all without going to the bank, writing a check, or digging in your pockets for change. Credit cards are so widely accepted that it seems only a matter of time before they will replace cash entirely. If you carry a no-annual-fee credit card, and you pay the card off in full every month, then you pay no interest on the borrowing. The convenience is free.

 Interest on some forms of borrowing is tax deductible. If you have equity in your home and the ability to borrow, you may be able to benefit from tax-deductible interest. If you have major expenses or other high-interest debt, you can take out a home equity line of credit and pay off or refinance the debt. In most cases, the interest on such loans is tax deductible, making the cost of funds cheaper.

 What are the dangers of borrowing money?

 Overspending is a risk when credit is readily available. When credit cards and home equity lines of credit are readily available, it is easy to overspend. A shopping trip can quickly turn into a no-holds-barred, bare-fisted spending spree, leaving your credit cards and equity lines tapped out. This may not be a problem if you can afford to pay the bill at the end of the month. All too often, however, consumers don't realize how much they have actually spent until they get the bill in the mail.

 Borrowing can increase the cost of goods purchased. If you make purchases on credit and pay them off over time, you end up paying the original purchase price plus a fee (interest) for the extension of credit. This means the cost of acquiring the goods is greater. In other words, it isn't really a sale if you buy that suit at 10 percent off using an 18 percent credit card.

For example:

Suit

$300

10% off

($30)

Sale price

$270

Credit card balance

$270

Paid off at

$15 per month

Total of all monthly payments

$317

Total interest paid

$47

Of course, total interest paid would be less if you made larger monthly payments and paid off the balance earlier. However, many consumers underestimate their ability to do so and end up increasing the cost of everything they purchase by paying excessive interest.

Caution: In addition to the excessive interest, there are annual fees and late payment charges that can further increase the cost of borrowing.

 Insolvency results from excessive borrowing. Insolvency is commonly defined in two ways. Insolvency is the condition of being unable to pay your debts as they come due. Insolvency is also defined as the condition of having more liabilities than assets. If you own a home, a car, and a house full of furniture, you may think you have plenty of assets. However, if you borrowed to acquire your belongings, you may be closer to insolvency than you think.

Example(s): Archie owns a house, his furniture, and a car. His house has a market value of $150,000. His mortgage balance is $100,000. The balance on his home equity loan is $40,000. He owes about $10,000 on the car he bought last year. It has a blue book value of about $10,500. Archie owns his furniture free and clear. A junk dealer said that used furniture did not have much value and offered a yard sale price of $1,000 for the whole bunch. In addition to his mortgage and car payment, Archie owes about $8,000 in credit card bills and $4,000 in back taxes. Archie has no savings to speak of and no personal belongings of any real value. Archie can't afford to make payments on his tax debt and still keep up with the other bills.

Is Archie insolvent? Yes, Archie is insolvent. He cannot make payments on his tax debt without leaving other creditors unpaid. Further, he has more liabilities than assets.

Many consumers carry high credit card balances. Many homeowners have mortgaged all the equity in their homes to pay college, medical, or other expenses. Given this situation and no other significant assets, you can easily find yourself insolvent and unable to pay your current bills, while interest, late fees, and penalties accrue daily. Always evaluate your financial situation prior to taking on new debt.


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