Debt Reduces Freedom

Hundred dollar car note
Two hundred rent
I get a check on Friday
But it's already spent
--Huey Lewis & the News

Previously we discussed the relationship between income, saving, and investing. We argued that saving and investing a portion of your income helps to elevate your prosperity and the prosperity of others. The sooner you get into the habit, the better.

But what about debt? How does it enter the equation?

Debt is the opposite of saving. Individuals take on debt when they want to live larger in the here and now than can be afforded by income alone. Suppose, for example, that you work a job that pays you $1,000 per month after taxes. If you put aside nothing for saving and investing, then you could live a $1,000 monthly lifestyle.

But what if you sought a higher standard of living--one that exceeded $1,000 per month of consumption? If you do not have past savings to draw from, and you don't want to work more hours, then you might consider borrowing the money that would allow you to acquire those additional economic resources that enable living larger. The lender of the money is sometimes called a creditor, and the borrower is called a debtor.

The basic loan contract works like this. The creditor loans you money today. In the future, you agree to pay back the loan. Loan repayment includes both the original amount borrowed, called principal, plus a charge for using the amount borrowed, called interest. Although loan contracts sometimes stipulate repayment in one lump sum, it is more common to repay loans gradually in regular intervals. Monthly intervals are common. Almost always, the longer the term of the loan, the more interest owed to the creditor.

With loan in hand, life seems good. You use the borrowed funds to consume more resources than your income afforded you. Just as you hoped, you're living large.

But then those monthly loan repayments commence. Now part of your $1,000 monthly income must be spent on servicing your debt. Pretty soon you not only can't afford the premium lifestyle anymore, but it becomes harder to live on your $1,000 monthly income. If your loan payments amount to $100/month, then that leaves you with only $900 to divide between consumption, saving, and investing. The more you borrow, the less you have left after paying your debt.

A few years back, a smart cookie summed it up for me in three words: Debt reduces freedom. Although the lifestyle 'sugar high' obtained from the original loan may seem liberating, that feeling is likely to be temporary. The reality is this: borrowing to fund a greater lifestyle today increases the probability of a lower standard of living in the future as those debts are repaid. Moreover, your future freedom is likely to be compromised. A loan can be seen as a contract of voluntary servitude. In exchange for the right to use the property of someone else today, you agree to work for that person in the future to repay what you owe.

The implications on saving and investing should be obvious. The more you borrow, the less you can save and invest for the future.