Pay attention to debt financing, December 29, 2006, 2D.

This year’s Christmas (and post-Christmas) shopping season is quickly coming to an end.  Many shoppers used credit cards to pay for their Christmas purchases.  There are many reasons why consumers use credit cards rather than cash, checks, or debit cards.  Some used them for the convenience that comes from being able to make one payment to the credit card company rather than many individual payments to merchants.  Others wished to take advantage of rebates and bonuses that they earn by using their credit cards.  Some wished to defer the actual payments of the purchases until the credit card bill comes due, and others used their cards because they did not have cash on hand and felt that borrowing the money through their cards was their best option.

The ability to purchase on credit makes it easier for consumers to buy the goods and services they desire.  The well-publicized downside to making purchases on credit cards is that they build debt.  Carrying too much debt prevents consumers from being able to save and invest money for use in the future or to take advantage of productive opportunities that come along. 

In some cases, acquiring debt to fund purchases is a desirable thing to do.  When buying a rental property, for example, it is often cost-prohibitive for buyers to fund the entire purchase with cash.  Rather, buyers pay a small portion of the sales price in cash and borrow the remaining funds from a lender.  The rent charged to tenants should cover the costs of the loan payment plus other expenses.

When goods and services are bought with debt financing, different sets of concepts arise.  Most things bought with credit cards do not provide a profitable payoff like a rental property.  Consumers must understand when to carry debt and when to pay it off.  Financial theory suggests that excess money should be used to fund the activities with the highest returns—or pay off debts with the largest costs.

If given the choice between an investment that returns 5 percent and one with equal risk that returns 15 percent, the alternative that returns 15 percent should be chosen.  The same principle holds true when evaluating whether to use money for investing or paying off debt.  Many credit card companies charge customers 18 percent (annually) or more on outstanding balances.  Paying off a debt with 18 percent interest should be thought of as an investment that yields an 18 percent return with no risk.  When excess cash can be invested to earn more than the rate paid on debt, the investment should be chosen over debt reduction.  In reality, however, very few investments provide greater rates of return (with no risk) than credit card rates.  Carrying a balance on a high-interest credit card makes little financial sense when the money to pay off the balance is sitting in low-return investment accounts.

With the advent of this year’s bill-paying season, spend some time evaluating ways to make your money work best for you.

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