Remember when pundits suggested the way to get rich quick was to use “Other People's Money” (OPM)? They pointed to real estate empires and stock market success resulting from investors leveraging debt to accumulate wealth. It's not as easy as it sounds.
I moved to Atlanta during the cable TV boom. Several friends worked for Scientific Atlanta, an innovator in cable TV boxes. They touted their stock; it was constantly doubling and splitting. I cautiously tracked the stock. It went from $16 to $32/share and split and moved up rapidly.
Friends confided they were introducing a new box that would “revolutionize” the industry. I hurriedly took out a second mortgage for $32,000 and bought 1,000 shares. I anticipated another split at $32 and another double. I'd sell, pay off the second mortgage, and take a couple decades off my primary mortgage.
It did not end well. They had a major product recall. Two years later I sold it all for around $16,000, leaving a balance on the second mortgage. Each month, as I wrote the check, I was reminded what a big mistake I made.
Borrowing money to buy assets you feel will appreciate over time makes sense – if you understand the risk and know what you are doing. banks lend money to businesses providing a business plan that clearly shows how the borrowed capital will improve their profitability. Even then, the best business plan can crumble if something unanticipated happens.
In retrospect, I'm glad it happened. Had my plan worked, I might have been fool enough to think I was smart, and probably tried it again on the next hot stock tip that came along.
Using OPM to buy assets that might appreciate is risky; however, there are far worse uses of borrowed money.
Using OPM to buy depreciating assets, or consumables has put many people on a debt treadmill that can take decades to overcome.
What is debt?
Debt is used in determining wealth. What you own (assets), minus what you owe (debt), equals net worth (your accumulated wealth). A person with $1 million in assets and $1 million in debt is broke! I've met some incredibly high earning “professionals” at the country club who fit that mold.
Many confided that they felt like they were on a treadmill trying to keep up with the monthly payments. The 1990's book, “The Millionaire Next Door”, summed it up this way, “Big Hat, No Cattle!”
Debt is borrowed money that must be paid back. Non-payment can have serious consequences. Interest is the rent you pay for holding/using other people's money (OPM). Generally, the higher the risk of non-payment, the higher the interest rate charged.
Let's look at different types of debt:
Auto loans use the vehicle as collateral. Autos (campers, boats and 4-wheelers) are depreciating assets. It's difficult to accumulate wealth owning and financing depreciating assets.
