Last month, we examined the first "financial deception" regarding debt: the idea that eventually debt can be paid back with "cheaper" dollars. This month, we examine three more deceptions.
Deception 2: The tax deductibility of interest
This deception says that because interest is tax deductible, it's a good idea to have interest expense in order to reduce one's income taxes. There's a certain amount of truth to that, but it doesn't present the whole picture. First, not all interest is 100% tax deductible. Consumer interest (credit cards, car loans, installment loans) isn't, and even investment interest has limitations. The only 100% deductible interest is home mortgage interest, and that has limits, too, when the mortgage goes above a certain amount.
Second, to say that an amount is deductible means only that it's deducted from income before computing the taxes owed. It doesn't mean that taxes are offset dollar for dollar by the amount of interest. For example, if you pay a total of 30% in state and federal income taxes, then for every dollar of fully deductible interest you pay, you reduce your taxes by $ .30, not $1.00. Thus, the net cost of paying interest is $ .70 rather than $1.00, but it's still a net cost, and it's never a benefit.
To clarify whether you should borrow based on the fact that interest offers a tax deduction, I propose this agreement: If you'll lend me $1,000, I promise to never repay you. That way you can deduct the $1,000 as a bad-debt expense and reduce your taxes accordingly. I, on the other hand, will keep the $1,000, report it as income, and pay the taxes. You tell me which of us will be better off. Interest deductions operate the same way.
Deception 3: It will cost more later
Again during the 1970s and early 1980s, when inflation rates were relatively high, a common advertising theme was "Buy now, because it will cost more later." In fact, it likely would cost more later. However, that ploy begs the true questions, which is not "What will it cost later?" but "Do I really need it?"
The second aspect of this deception is the underlying assumption that everything will continue to go up in price. That's not always the case. Personal computer prices, for example, tend to start high when a new model is introduced and fall steadily. And almost everything goes on sale periodically.
The way to understand the real question when tempted by this deception is to ask, "So what?" In most cases, the answer is "I may not need it later" or "The future price makes no difference to me, because I have to have it." But making a purchase on the basis of its costing more later is a very short-term perspective and may well be a financial mistake.
Deception 4: The magic of leverage
In graduate school, I was taught the value of OPM — the use of other people's money. The idea is that if you use debt to purchase something, you get a far greater return on your portion of the investment than you would if you paid all cash for it.
The classic example has again been the purchase of a home. If you were to purchase an $80,000 home and put 10 percent down, you would have a net investment of your own money of $8,000. If that home then appreciated 10 percent in one year (meaning you could sell the house for $88,000), you would have a 100 percent return on the money you invested (an $8,000 gain on an $8,000 investment). If, on the other hand, you paid cash for the home, you would have achieved only a 10 percent return (an $8,000 gain on an $80,000 investment). The difference between a 100 percent return and a 10 percent return is the magic of leverage.
This concept will work as illustrated if the underlying assumptions hold true. The basic assumption is that there will be appreciation rather than depreciation on whatever is purchased — an idea I've already shown to be false. The second assumption is that if you borrow money instead of paying cash, you have an alternative use for the money that will yield a return greater than your cost of money.
Many people have gone bankrupt trying to take advantage of leverage. They didn't understand the real assumptions they were making. Even huge lending institutions all over this country have gone bankrupt because they lacked this understanding. Leverage can work for you, but it's like riding an alligator: It's a lot easier to get on than it is to get off safely.
The best way to conclude is to advise you that if a deal sounds too good to be true, it probably is. Second, be very careful when accepting counsel from anyone, including supposedly knowledgeable business and professional people. Truly successful people become well off not by using complex techniques or even by reducing their taxes to nothing. Instead, they become successful the old-fashioned way: They earn it. The key to financial success is to spend less than you earn and do it for a long time. There are no shortcuts to taming the money monster.