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Credit - Other Peoples Money

There are two kinds of credit.  One is consumer credit, the other is investment credit, often referred to as leverage.

Consumer credit

Consumer credit usually credit cards, car loans, home loans, etc.  If used properly and with forethought consumer credit can be useful and has a place in most people lives.  When it is misused it can be very destructive to your personal finance and may lead to personal bankruptcy.  Credit is easy to get, expensive to use, and easy to misuse.  People who use credit cards as opposed to cash have been shown to spend 23% more on everyday shopping trips, The Peoples Almanac, Doubleday & Co. 1975.  It is easy to see how this can lead to trouble.

Signs of credit problems:

• Family arguments over money
• Past-due notices or creditors calling
• Credit lines pushed to the limit
• No savings
• Relying on credit to pay monthly bills, even charging credit card payments

Building or rebuilding credit:

This procedure uses the concept of secured credit .  We will use a savings account to secure a new credit card.  Banks will often issue a secured credit card to anyone provided that they have an offsetting savings account pledged for the cards repayment.

• Open a small savings account and pledge it as security for a new credit card.
• Borrow cash against this new card and open a second savings account at a second bank and obtain a new card, repeat one more time with a third bank.  Place the final secured loan proceeds in a savings account and do not touch this account because you will need this money to pay off the cards after your credit is reestablished.
• Do not use the cards for any thing but gas or essential purchases you would have made anyway.
• Be very careful to make all payments promptly  and zero out your balances each month.  After three months or so you should be on your way to reestablished credit rating.  If your credit has been especially poor it may take a year but lending agencies are often quick to forgive a past credit history in the face of current performance.
• When your credit has been reestablished to your satisfaction, pay off the secured loans with the money you have secured from borrowing against the cards.
• In this exercise you have used one small savings account to create several small savings accounts and several secured credit cards.  Banks were willing to lend to you because your credit cards were secured by your savings account, and because your accounts were secured, you probably were able to negotiate a lower interest rate than and unsecured card (ask for this discount if it is not offered).   you were able to close out all of the loans by using the money you placed in the final savings account and your interest expenses and fees were minimal and offset in small part by the interest you earned on your final savings account.

Leverage - the business application of borrowed money to either make an investment, or to increase your return on your out of pocket cash.  Often referred to as Other Peoples Money, or OPM for short.

Lets look at an example of this concept of leverage.

In this exercise you use all cash, no leverage.  Imagine you have one-hundred thousand dollars cash to invest in an opportunity.

Scenario One - you invest all $100,000 in cash, and later sell for $110,000.  You have made $10,000 profit ($110,000 sale price - $100,000 investment), a ten percent return.

Scenario Two - you invest the same $100,000 but your investment consists of $10,000 of your money and $90,000 of borrowed money (leverage).  You sell the same investment for $110,000.  You make the same $10,000 profit ($110,000 - $90,000 repayment of loan less $10,000, your cash contribution) but your return has increased to a one hundred percent return.  After paying off your loan (loan fees and interest ignored in this example) Your made a $10,000 profit and you only put up $10,000 of your own money.  I repeat a one-hundred percent return!

Now the bad news

Leverage can also increase your risk consider the first scenario but in this example your investment instead of increasing by $10,000 decreased in value by $10,000.  Your investment is now worth only $90,000. You lost ten percent of your investment.

In the second scenario your investment decreased by the same amount but now you have lost one-hundred percent of your money.  You still owe your creditors $90,000 plus interest.  Not a god situation.

The use of leverage can be and extremely useful tool, but it is important that it be used well.  If consumer debt is spent for new toys and life style, it is misused.  Spending begets spending.  A new home also means new furniture and appliances. A new  couch then new end tables and lamps to complement the couch  Then painting to match the new furniture. New carpet to match the furniture and paint. Finally a new house to accommodate all the new furniture..  A raise used to increase life style feeds on itself and often outruns itself leaving its recipient often poorer after receiving a raise.

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