Definition:
1. everything you buy or do that costs you money is financed 100%
This principle is one of the trickiest to understand because it is so counter intuitive. Why? Because conventional wisdom tells us that if we pay cash for something there is no debt. If there is no debt, there is no financing. In a sense, it’s free. The fact is that everything is financed 100%. It’s either financed with your money, other people’s money or a combination of both. Again, you may ask, “if there is no debt, how can it be financed?” Let me explain with the following example.
If you had $100,000 in the bank (money invested with any institution I will generically refer to as “The Bank”) and that money was earning a 5% Annual Rate of Return, at the end of a year you would have earned $5,000.
Initial Investment = $100,000
Rate of Return = 5%
Gain = $5,000
Formula: $100,000 x 5% = $5,000
Now, let’s say you purchased a home with your $100,000. Many people want to pay cash when they purchase their home because they do not want to owe anyone any money and they do not want to make mortgage payments. By paying cash, however, they are giving up the “opportunity” to earn money from their money. This is the essence of The Opportunity Principle.
In this example, they gave up $5,000 and more, much more. Not only did they give up $5,000 in the year they bought their home, they will continue to give up $5,000 each and every year going forward. In fact, they will not only give up $5,000 every year, they will also give up the interest they would have earned on that $5,000 as well. This is the Principle of Compound Growth, or in this example it would more accurately be described as a Compound Loss, which I will describe later in depth.
When you pay cash for something, essentially, you have loaned the money to yourself. While you will never have to pay yourself back, you will never foreclose on yourself and you will never report yourself to the credit bureaus, that fact is that buying things for cash comes with a cost.
Again, everything is financed 100%. This is not a choice. This is a Principle. You can choose to ignore it. You can choose to not like it. It really doesn’t matter. Principles always work, always have worked and always will. The fact is that everything you do or buy that costs you money is either financed with your money, other people’s money or a combination of both.
Once you acknowledge this fact, then there are only four questions you need to ask yourself when choosing among the options available to you. These questions serve as a 4 Step Filter to help you make the right choices and decisions concerning your financing options:
1) If I finance this with other people’s money, can I afford the payments?
2) If I finance this with my money, am I willing and able to give up the liquidity?
3) If I finance this with my money, am I willing to give up the opportunity to earn money from my money?
4) If I finance this with other people’s money, am I incurring Productive Debt or Reductive Debt?
The 1st filter is about cash-flow. Do you earn enough income to afford the payments required to service the debt? How much debt you can afford is based not only on how much you earn. You need to understand if your income is stable, variable. Is your income increasing or declining? Your situation is unique. Do not allow the lender to make this decision for you. In general, lenders (those who lend out other people’s money) are willing to lend you far more than you can afford. Why, because they will charge egregious interest rates knowing that while many will fall behind on their payments or default on their debt altogether, many more will find a way to pay their bills. In the end, most lenders of other people’s money are well rewarded for extending their customers too much credit.
The 2nd filter is about liquidity. Liquidity is important for two reasons. 1) Things go wrong in life, and when they do you need cash on hand to help you to weather those financial storms. 2) Opportunities present themselves, and when they do you need liquid cash to take advantage of them. The amount of liquidity YOU need is unique to YOUR situation; your age, your income, the amount of debt you have and so on. We will discuss the importance of liquidity later.
The 3rd filter is about The Principle of Arbitrage. Arbitrage is when the Rate of Return your money earns is greater than the cost of borrowing other people’s money. We will address The Principle of Arbitrage, in depth, later as well. (Footnote, we have not discussed risk as of yet. The fact that you could possibly earn a high Rate of Return on your investment must also be reconciled with the risk you must take to earn that return. Understanding and evaluating risk is an extremely important concept and generally misunderstood or ignored altogether.) Assuming that you can afford the payments, have sufficient liquidity and you can earn a higher Rate of Return with your money than your cost of borrowing other people’s money, move to filter #4.
The 4th filter is about understanding the kind of debt you are acquiring, Reductive or Productive Debt.
Reductive Debt
Reductive Debt is generally used to buy “Stuff” or to do “Things”. Stuff and Things are a technical terms for items that we consume or depreciate in value like cars, boats and other toys (another technical term) and doing things like dining out. Stuff and Things generally provide you with lifestyle. If you take on Reductive Debt to buy stuff or do things, then you are making a poor decision every time.
I am not advocating that we become misers and live in caves. We need to enjoy the fruits of our labor. We need to enjoy our lives by doing things, giving to others and so on. What I am saying is that there is no free lunch. Everything is finance 100%. Financed buying stuff and doing things with your money by paying cash! If you don’t have the cash, wait until you do.
Productive Debt
Productive Debt makes you money. Productive Debt is used to buy appreciating assets like real estate. Productive Debt is used to finance other activities that make you money like businesses or taking on inventory to resell at a profit. Productive Debt, by default, passes filter #3 in that the Rate of Return from the earnings of your money will always exceed the cost of borrowing other people’s money. Productive Debt combines the Principles or Leverage and Arbitrage to amplify your returns. Productive Debt is good debt and, as long as you can afford the payments and have sufficient liquidity, you can and should acquire all the Productive Debt you can comfortably and safely afford.
The Opportunity Principle states that everything you buy or do that costs you money is financed 100%. The only choice you make is will it be financed with your money or someone else’s money. Money spent is money gone and there is a cost associated with that decision. Every penny we spend is a penny that could have been earning income instead. Once spent, that money and the money you could have earned from that money is gone, forever!
When it comes to winning the game of money, credit and finance I hope that you will agree that understanding The Opportunity Principle and using this 4 Step Filter to make better choices and financial decisions is simply a better, smarter safer way!
It’s a good life!
Randall A. Luebke RMA, RFC
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