Often I am asked, "How do we get out of debt and stay out?" My advice is simple but not simplistic.

More deception (most of it unintended) is perpetrated by accountants, bankers, business schools, and businessmen regarding the use of debt than most of us realize. We tend to respect these professional people. Yet they only pass on what they've been taught, and in many cases they've been taught half-truths. Being a CPA, former banker, alumnus of a graduate business school, and businessman myself, I remember what I was taught and have in turn taught others in time past. And there are four major financial deceptions conveyed implicitly or explicitly by my peer group. They are as follows:

  • Borrowed money is always paid back with cheaper dollars in the future.
     
  • The tax deductibility of interest makes using debt a wise thing to do.
     
  • Inflation is inevitable; therefore, it is always wise to buy now at a lower cost than in the future at a higher cost.
     
  • Leverage (debt) is magic.

Perhaps I'm too critical in calling these deceptions, because they may or may not be true depending on certain assumptions. But the assumptions underlying the four statements are not adequately explained. So to better understand the whole issue of using debt wisely (if, in fact, you should use it at all), you must recognize these deceptions and evaluate them relative to your own circumstances.

Deception 1: paying back with cheaper dollars

In the 1970s and early 1980s, inflation was at double-digit levels and was projected by almost everyone to be ever increasing. The "wisdom" then was that you would always be able to pay back borrowed money with dollars that were worth less in the future, because inflation eats away at the purchasing power of money. This wisdom was true as long as two basic assumptions were met. The first was that you were able to borrow at a fixed interest rate so your rate did not increase with inflation. The second was that inflation would continue.

The example used most frequently to sell this deception was the purchase of a home using a fixed-rate, long-term mortgage. This does in fact make sense in a time of inflation, because the dollars used to pay back the principal amount borrowed are worth less and less. In addition, when the interest rate is fixed for the life of the loan, you can't be hurt by the increasing interest rates that go hand in hand with inflation. That approach continues to make sense if the two assumptions continue to be valid.

History proves, however, that there are economic cycles. They may not be geographically universal, but they do occur. For example, if you bought a home in the Southwest in the early 1980s, you would have paid a premium price. But when oil prices fell and the economy turned south in the Southwest, the assumption of continuing inflation proved to be wrong.

Other illustrations abound. Midwest farms in the early 1980s were selling as fast as they came on the market at prices that eventually reached $4,000 per acre. By the late 1980s, however, that same premium farmland could be purchased for $1,200 to $1,500 per acre. The point is that even if inflation were a valid assumption overall, it may not be valid for the region in which you live. When industries leave an area, inflation changes. There aren't as many people demanding the same goods and services, so prices tend to fall. Thus, what is true today regarding inflation may not be true tomorrow.

The idea of gaining an economic advantage by borrowing at fixed interest rates so your rate doesn't go up with inflation assumes that lenders are basically stupid and will continue to lend money at low, fixed rates for long terms even during times of inflation. That's not the case. In periods of inflation, interest rates rise, and lenders promote adjustable-rate mortgages. They also know that the average home loan will mature (be paid off) within eight years as borrowers sell or refinance. Then the money from the payoff of that mortgage can be reloaned on the same house at a higher interest rate. Additionally, every time they make loans, lenders can charge points and fees that increase their income. Thus, they don't make bad decisions even when they're willing to make fixed-rate loans. They push as much of the risk to the borrower as they possibly can. And in times of inflation, they charge premium rates.

Whenever you borrow money at a premium interest rate, the fact of paying back with cheaper dollars in the future is mitigated by the high rate. In my 20 years of professional experience, interest rates on credit card and installment debt have never been lower than the inflation rate except for very short periods. So while you may repay the loan with cheaper dollars in the future, the premium interest rates charged more than offset the benefit.

Coming next month: A discussion of the other three financial deceptions.