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The following article
was written by Coleman Patterson and
appeared in the Business section of the Abilene Reporter-News.
Pay attention to debt financing, December
29, 2006, 2D.
This years 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
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
returnsor 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 years
bill-paying season, spend some time evaluating ways to make your money work best for you.
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