Credit and debt — what’s the difference? I’m going to address that because a lot of your average everyday working people don’t really know the difference. But its understandable because there’s a really fine line separating the two. There are also special interest groups that have purposely blurred the lines, but that’s another topic. So let’s dive into this topic head first!
First, let’s talk about credit. Credit is simply borrowed money that is expected to be repaid with interest. Another way of putting it is — credit is a method people use to spend today and pay back tomorrow. Ideally, when a person uses credit, they would apply that credit towards the purchasing of an asset that appreciates in value….like a business. Or, for everyday people, they’d use credit towards a home. But we’re gonna discuss businesses for the remainder of this discussion.
When a person uses credit towards starting a business, that person is using borrowed money in order to enhance their returns. At least, that’s what is expected of them. They could use this borrowed money for purposes such as opening a new location, buying new equipment, creating new products, hiring additional staff, research & marketing to reach a bigger customer base, etc. All of those actions are taken in order to contribute to a business increasing their bottom line (profit). So, when it comes time for that business to repay their loan, if the company has done a good job of managing their funds and remaining solvent, they’d have no problem repaying the loan on-time with interest; and on top of that, they’ve made a profit. In this case, both the lender and the company are happy.
Now let’s talk about the dark side of credit, which is debt. Debt arises when a person misuses credit. This typically occurs when a person takes out a loan to purchase an item that only depreciates in value. The most popular scenario is an automobile. Let’s say that you finance a car for $30,000 at 5% interest. I’m not even gonna mention tax and the other fees they charge for a car loan. Your loan might be for 3-5 year with a monthly car note payment of around $525. A year after you’ve bought the car, it’s value drops to $22,000. But you’re still on the hook for the full amount plus interest. Another year, its dropped to $15,000. If you’ve been paying your note, you’ve paid $12,600 of the final amount, leaving you with a remaining balance of nearly $20,000. As you can see, you’re stuck paying a note on a car that’s for more than its worth. Even if you tried to sell the car at its current $15,000 valuation, you’d probably find a buyer for $10,000 at the most. Now you’ve sold the car for $10,000 and you’re still owe substantially on a car that you no longer own. What I’ve just described is how credit can easily turn into debt. Technically speaking, all credit is debt until that credit is repaid in full.
That same scenario, by the way, is also how a lot of homeowners ended up underwater on their mortgages in 2008. They purchased a home for $200,000 with 3% interest (compounded), bringing their total credit obligation to $485,450. When the Real Estate crisis hit, homes plummeted in value. That same $200,000 home is now barely worth $100,000. But the homeowners still owe the full amount…unless the lender agreed to some sort of debt restructuring. Even if the homeowners sold their homes at the current $100,000 valuation, they’d still owe what they haven’t paid of their original mortgage. But, they’ve launched numerous programs aimed at getting homeowners off the hook for what they owe. So now the homeowners are deep in dept because their loan turned out to be for a depreciating asset. Make no mistake about it though, during the Housing Bubble, there were a lot of people using these same loans to buy homes and sell them for a quick profit.
Those two scenarios of credit turning into debt may seem like pretty extreme example, even though a lot of people are dealing with both. So we’re gonna talk about the most basic form of credit — the credit card. What we call credit cards in our society should actually be called “debt cards.” They tell you that your card represents credit, when in a sense, it does. BUT, 9 times out of 10, you’re gonna use your credit card to buy items that decline in value…items that don’t produce a return on investment. A great number of people have credit cards and they use them for basic living expenses. Whatever their income doesn’t cover, they use credit cards to cover the rest. Because they already don’t make enough money to cover their living expenses, how are they going to repay these credit card loans plus the interest? They usually don’t, which results in the card holder going into debt.
You now see how the line between credit and debt has been blurred. On one hand, you have a person who’s using credit as leverage to generate a profit. On the other hand, you have someone who’s misusing credit to buy an item that declines in value, putting them on the hook for the full amount of the loan despite the depreciation of their investment. By the way, there are a lot of people borrowers who actually have the cash to outright buy what they’re financing. But they only finance those items because they prefer to pay them off over time instead of dropping one big pile of cash. Which is perfectly fine.
Before we had a money system, people would lend/borrow crop seeds and animals and yes, there was interest. The idea was that if a person borrow seeds to plant a crop, the interest they’d pay the lender would be the sharing of their harvest. Or, if a person borrowed cattle, they’d repay the lender by sharing the cattle’s offspring. The point in me sharing that bit of history is to say that in those days, people lent/borrowed items that could produce a return. You could plant a seed and get a lot more crops than you started with, or you could borrow an animal and that animal could reproduce. But when you’re borrowing money, money can’t reproduce. So, unless you have a plan for the money you borrow to produce more money typically through some sort of an investment vehicle, its probably best that you don’t borrow at all.