This is a guest post from Kevin, who blogs at 20smoney.com.
Personal finance is pretty common-sense stuff if you think about it. Yet, the majority of the public fails to implement this common sense into their daily lives. For instance, I believe the cardinal sin of personal finance is borrowing money to pay for a depreciating asset. If you think about, almost every person you know does just this. Worse yet, despite being common sense personal finance stuff, this idea is not only accepted as a societal norm, it is encouraged at every level of our society and economy.
Borrowing money to pay for something that is losing value is definitely not the path to wealth generation. Let’s look at a few examples. The most common example, that you probably thought of immediately, is purchasing an automobile. New cars are notorious for losing value, yet almost everybody borrows money to buy them. Why? Because we need a car? Well yes, but we don’t need a 2011 Lexus. If we all bought strictly based on our actual needs, we’d all pay cash for a clunker that does nothing more than get us from point A to point B.
An automobile is a pretty straight forward example. My next one might be a little more controversial.
What about a house?
Most of us borrow money to finance a house. The problem is that at some point in the past, everybody began to view a home as an investment versus an expense. This all changed with the real estate bubble crash a few years ago. If you ask random people on the street, however, most would still tell you that a home is still a good long-term investment. As such, it makes sense to borrow money. I would encourage you to reconsider this societal norm. Housing is an expense, and we’re not likely to see a return to the good ol’ days of constant real estate appreciation for many, many years in my opinion. Read reasons why here and here.
This is the cardinal sin of personal finance because you’re allocating money towards something that is losing value, and you’re paying interest on top of it. This is the opposite of investing for wealth generation.
Why Do We Borrow Money For Depreciating Assets?
The first reason is that our government encourages us to do so. Our economic policy is one that encourages and incentivizes debt and punishes savings. For example, you can write off your mortgage interest, yet you pay taxes on the interest generating by your savings account. That’s pretty clear. Most mainstream economists believe that incentivizing debt stimulates economic activity and is, therefore, a good thing. This has been the policy in America for many, many years.
Although I support changing these policies, it’s worth noting that a shift in this policy to discourage debt and encourage savings would immediately result in a massive economic slowdown (more than already experienced) and a painful recession due to our economy being very dependent on debt-financed consumption. As such, don’t expect short-term thinking politicians to make any changes in this area.
Second, Americans have become accustomed to a standard of living that exceeds our ability to fund it. Therefore, we have to borrow money to fund this standard of living. This party has come to an ugly end in recent years, and I expect the ugliness to continue for some time.
What’s The Alternative?
The alternative to borrowing money to buy depreciating assets has a few key points.
1. Limit the depreciating assets you buy and pay cash for them. You need a car and you do need other things that lose money. Instead of buying something you can’t afford and borrowing money for it, buy something less expensive and pay cash for it.
2. Invest in cash-flowing assets. Invest continually into cash-flowing assets or assets that generate a return. These might be rental real estate or dividend-paying stocks. Don’t borrow money to buy these assets. Instead, work hard to set money aside and continually invest. This is more important than finding the perfect stock or investment to buy.
Trade a lower standard of living for financial freedom: Get used to a lower standard of living. This might mean a used car and a smaller house, but by limiting your expenses, you set yourself up with excess cash to fund cash-flowing assets and build real wealth. This can lead to financial freedom.
If you excel at one thing with regards to personal finance, aim to excel at avoiding this cardinal sin. By not borrowing money to finance depreciating assets, you will be well ahead of the average American. Good luck.
Read more of Kevin’s writings at 20smoney.com.