Have you seen the latest Big Shiny Thing? It’s awesome, it’s amazing, and you just have to have it. True, you only have about 20% of the cash you need to buy it… but that’s not a problem. You can finance the Big Shiny Thing, putting the cash in as a down payment, and then borrow the rest at a moderate interest rate. Over the course of the next five years or so, you’ll make monthly payments, and eventually pay off the debt.
It can sound like a fantastic deal. You really want the Big Shiny Thing, but you can’t buy it right now with the cash in your hand. Borrowing money to make the purchase seems like the perfect plan. It allows you to buy the thing you want now, even though you don’t have the cash. It’s like a giant lever, that lets you lift the big price tag with the small purchasing muscle you have. Borrowing money, we’re led to believe, increases our buying power.
Or does it?
The most predominant myth about debt in our culture is that borrowing increases your buying power. The problem is that this just isn’t true. In fact, the opposite is true: Borrowing decreases your purchasing power, because the interest you pay in the long run adds a lot to the cost of the item.
Let’s walk through a simple example, using round numbers for easy computation. Big Shiny Thing costs $5,000, but you only have $1,000 to spend. So to buy it, you borrow $4,000, at a 5% annual interest rate (a modest rate for consumer purchases). You agree to pay the loan back over the course of five years. That works out to a monthly payment of about $75.
What’s the problem? Well, after five years of paying $75 per month, you will have paid back a total of $4,500. Combine that with your original down payment of $1,000, and you end up paying $5,500 for your Big Shiny Thing, even though it’s only worth $5,000. That, my friends, is not an increase in your buying power; in fact, paying more money for the same item is the very definition of a decrease in buying power.
You may say, “Well, $500 is a small price to pay for the enjoyment of having the Big Shiny Thing now.” Indeed, that’s the reasoning that most borrowers use. But the problem is that you could use that $500 for other things — food, vacations, or other, smaller shiny things. You would have the power to spend that money as you like… but because you borrowed, that money is already sunk. (An even more sobering thought: If you invested the $75 monthly payment into a mutual fund with an average annual return of 10%, and continued making that monthly investment for 40 years, you would end up with nearly $400,000 in your account!)
So the myth that debt increases buying power is busted. True, borrowing allows us to have things now, but we pay more for them in the long run, and tie up money that we could be using for other things. In the process, we’ve let some of the money that God has entrusted us with slip away.
What’s so smart about that?