Tuesday, January 14, 2014

Understanding the difference between credit and debt. One makes us happy and the other doesn't, right? Why are we so dumb when it comes to this distinction? Find out here!

My cyber friend over at The New Arthurian has a posting (HERE) I think is very important for students and young adults. It will make your financial life much better if you understand the distinction between "Credit" and "Debt".
No debt produces anything. New uses of credit can sometimes be for productive purposes. But after that money is spent, nothing remains but the evidence that it was credit we were spending: Nothing remains but the debt.  
Debt is evidence of credit use. Debt is the cost associated with credit use. 
Borrow a dollar today, spend it today, and boost the economy today. Tomorrow, nothing remains but a dollar of debt, the cost of interest on that debt, and the cost of repayment. These costs do not boost the economy. Just the opposite, in fact. This is true no matter who borrowed the money. It is true, no matter what the money was used for. 
In the short term your income is fixed.  After you pay taxes what you have left over is termed your "disposable income".  All of that disposable income will go towards meeting "needs" and "wants".

Going outside of our disposable income to buy something with credit to meet a need and/or want leads to a debt that requires us to pay, not only the amount we borrowed, but the interest for the privilege of having that credit extended to us. That principal and interest did not exist to us before.

It WILL exist going forward and BOTH will have to be paid for out of your fixed disposable income.

When you pay interest on a debt it means an amount of money comes out of your disposable income that you COULD HAVE used to buy something else.  But you can't. Probably not for a long time. You committed future earnings to pay for this past purchase when you accepted the credit. I repeat: a part of every paycheck going forward is committed to a past purchase.

The original amount you borrowed PLUS the interest payment is the present opportunity cost of using credit.  It prevents you from new consumption this month, next month, next year...

Better be happy with what you bought on credit.

Here is the litmus test:  Does what you bought in the past on credit bring you the same satisfaction TODAY as what you could purchase with that principal and interest tomorrow?

Perhaps that is a false choice.  However, when I think about it in these terms AT LEAST it makes me pause and consider if that purchase is something I want to serve as a drag on my future consumption.

Hope this helps you make better financial decisions!
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