It seems like the newest shopping trend is to offer enjoy-now-pay-later on EVERYTHING. You could be purchasing a new barbecue or a pair of pajamas, and a financing option will populate at checkout. Companies like Klarna and Affirm are trying to entice buyers to split up their pajama purchase into 12 easy payments of $1.23 per month.
Think about what a personal finance evolution this is. I remember reading a book where the author was giving an account of a trip to Turkey and his fascination with all the half-built homes. His guide informed him that these families would save money for materials, build a portion of the home, then return to work until they could afford the next phase of the project. In America, about 3 out of 5 owner-occupied homes have a mortgage – a distinct cultural difference from what was described above.
Let me be clear: this article is not a critique of financing. We have just come a long way from layaway to the financing of everything. As the popularity, accessibility, and ease of use of credit have risen, the art of counting the cost has nearly become extinct.
Balance Sheet vs. Cash Flow
To fully grasp our discussion today, we need to understand the difference between a balance sheet and cash flow.
Imagine if you owned a home free and clear worth $500,000. You had an annual income of $100,000 and bank savings of $50,000. Your balance sheet would reflect the $550,000 of home equity and cash savings; your cash flow would reflect your $100,000 income. Now, imagine a $75,000 expense came up. If you don’t want to dip into your savings to cover this cost, then you will need to finance the expense. Financing means that this $75,000 will be split into small payments (principal and interest) that are paid over a defined time period.
So, what really is financing? It is a burden on future cash flow. You will enjoy a product or service today, and the cost will be debited from your future cash flow.
Here’s where this becomes complicated. If you are financing one item, perhaps you can back-of-the-napkin the impact it’ll have on your monthly spending, but what if you are financing two things or five things or everything? Then the math just doesn’t fit on the back of a napkin.
Could I vs. Should I
There is a common finance adage out there that consumers don’t buy a price; they buy a monthly payment. Whether it be a mortgage or a car loan, consumers become laser-focused on the monthly financing cost. Buyers use this monthly price tag to do some quick mental math to decipher whether they can afford the purchase.
Often, there may not be sufficient savings to make the purchase outright, but there is a lender willing to stake a claim on their future cash flow. This is where the question of “could” I afford this becomes dangerous. The math could all check out that there is room in one’s cash flow to finance this new sofa, but the burden of that ongoing payment may not be fully appreciated through the fog of that new-purchase euphoria.
The better question is “should” I afford this? Do I want to allocate my future resources (cash flow) to this particular item? If I make this commitment, are there other commitments that should take greater priority that will be crowded out by this decision?
Offers to finance are really marketing disguised as a helping hand. Marketing is meant to entice you and get you to make a decision sooner rather than later. Financing makes big purchases and big decisions feel doable and smaller than they seem.
I recently heard Morgan Housel say it this way, “The best math you can learn is how to calculate the future cost of current decisions.”
Interest Expense vs. Interest Earned
Another term for financing is leverage. This synonym gives you a better visual that borrowing can enhance the growth of a balance sheet. If one is to borrow at a lower rate than their expected rate of return on their investments, then this will create an accelerated growth of wealth.
So, if I have a million dollars invested earning 8%, then my interest earned would be $80,000. If I also purchased a million-dollar home that I financed at 6%, then my interest expense would be $60,000. The $20,000 difference between my interest earned and interest expense represents the additional return generated from leverage.
What I stated above is textbook true. Now, here are two realities that I see happening in the real world that challenge this concept.
First, I see investors who have both heavy allocations to cash and debt on their balance sheet. They may have a mortgage with a relatively low interest rate (e.g., 4%) while also having a large balance in their checking account. Here’s the disconnect: this investor doesn’t view their balance sheet holistically – they like the attractiveness of a relatively low-rate mortgage, and they like the comfort of having a high balance in their checking account. The reality is that an interest expense that is greater than interest earned creates a headwind on wealth accumulation. Sure, this combo of cash and mortgage creates liquidity, but there are other ways to achieve the same liquidity without the described headwind.
Second, I see investors who resource financing with the intent to create a positive interest earned over interest expense. This investor obtains the million-dollar mortgage to retain the million dollars for investing. This investor may even build a portfolio with an attractive expected return. Everything is on track, but here’s the problem. That mortgage may be in place for 30 years, and in order for this textbook calculation to play out, the investment portfolio needs to remain undisturbed for that time period as well. Over these 30 years, a lot of attractive luxury purchases are going to rear their ugly heads – a new boat, a European vacation, a second home, etc. – and that investment account may feel like it’s burning a hole in your pocket. It’s hard to stick to a plan, and self-control just isn’t a common human strength.
Overcommitted
I’m currently in that season of life where our calendar is devoured by kids’ sports. It’s incredibly fun, but also incredibly busy. This fall, our two boys wanted to play soccer and flag football. Football games are Friday nights and soccer Saturday mornings. My initial reaction was, “Ok, that’s not so bad – Friday nights, Saturday mornings.” My arithmetic was a bit off. Here’s the real math: (1 practice + 1 game) x 2 boys x 2 sports. That’s 8 calendar commitments. Yowza is right.
Sure, it was easy to say yes to two sports for two boys, but who was really going to pay the price? My future self (and my wife), as we play Uber driver, snack provider, dirty laundry washer, etc. Our personal finances are the same. We lightheartedly make commitments that we literally and figuratively will have to pay for later. If you study your monthly spending, it’s full of expenses that are the result of past decisions – streaming subscriptions, auto loans, student loans, etc.
Again, this article is not a critique of financing, but rather an advocacy for us to count the cost. I love that we have fully built homes in our country and that we have the opportunity to enjoy those homes while we pay the cost over time. At the same time, many Americans are overcommitted financially, and these commitments create pressure, stress, and reduce the flexibility of one’s financial plan.
I’ll leave you with these final words of wisdom: For which of you, desiring to build a tower, does not first sit down and count the cost, whether he has enough to complete it? (Luke 14:28).
Trevor Cummings
PWA Group Director, Partner
