Lately, I’ve been doing a lot of work with the students that I work with discussing the bigger strategic elements of building wealth along with the primary tactics. What I like to do in particular is to focus on those elements that either create wealth or those that eliminate expenses. However, when I get the chance to focus on a broader tactic that includes aspects of creating wealth AND reducing expenses, that’s the wealth building One Two Punch!
There’s a One Two Punch in wealth building that is as worthy as being the single most important aspect of wealth building as any other that I know (I seem to be saying that a lot lately!).
The first part of this One Two Punch combination is this timeless advice:
Never use debt to finance an item that doesn’t generate income.
What this advice is meant to do is to always put us in a position where we would never encumber ourselves financially where the mechanism of ‘compound interest’ is working against us.
Never forget the power of compound interest and how it works for us. But never, EVER forget the power of compound interest when it is working against us!
Not only does it take wealth building funds out of our hand in the form of costly principle payments but it also accelerates this phenomenon in the form of interest that must also be paid. Both of these wealth denying forces are now working solidly against us and when we take into consideration what we are NOT able to save and invest as a result, it adds up to REAL money!
Simply stated, never use debt to finance a car, furniture, jewelry, clothes, consumable items, vacations and here’s one that up until not so long ago was deemed highly controversial (see my post https://thefinancialstoic.com/?p=223 where this is discussed) your single family occupied house.
Using a now pretty common identifier in the wealth building space, this is ‘bad debt’. Bad debt is anything that is financed against something that is not generating income but also might inherently be worth less than when it is purchased (car, clothes, jewelry, furniture, etc.)
How does Opportunity Cost work against us?
Remember our good friend ‘Opportunity Cost’? Sure you do. That’s the thing that works against us from building our wealth by diverting potential wealth building dollars away from investments working on our behalf and funnels them into wealth depriving activities such as having to pay debt service to someone else.
Let’s do the simple math on this. If we take out a mortgage on our single family “non-income generating” house that we live in for $200,000 at an interest rate of 3.1% (as of today) for 30 years we would have to pay $107,282 additional dollars to pay on interest for a total payment for that $200,000 house of $307,282 dollars.
That additional $107,282 dollars paid in interest equals on average over these 30 years to roughly $300 per month.
Now here’s the VERY scary math. If we were to have taken that same $300 each month that we otherwise would have been paying for interest on that house and now put that into a wealth building investment account earning 7% annually we would have a little over $355,000 in wealth after that same 30-year time frame.
Wait a second! What just happened here? I thought it only COST us $107,282 in interest in that same period? How could that now equal $355,000 in wealth to ‘our good’? This is the lulling effect of debt. It ONLY cost us $107,282 because we were borrowing at a much lower rate, 3.1% over that same time frame, but it was DEPRIVING us the ability to have made wealth at 7% over that same time frame. THAT my friends is Opportunity Cost https://thefinancialstoic.com/?p=127 in full motion!
The more we borrow for non-income generating items the more we deprive ourselves of wealth
Now I realize that we wouldn’t have had ALL of that $300 to invest in the above example, as we would have otherwise needed to pay something to borrow those funds, but the point is that the more we take on debt for non-income generating assets the more it deprives us from generating wealth.
Think about this activity if it had been a new vehicle? You’d be paying a similar interest rate over 5 or 6 years nowadays for something that will be worth pennies on the dollar when you are done financing it.
Seeing the math in motion always takes something theoretical and puts it into real world circumstances. From the example that I provided, I hope that I described the crippling effect that debt has on wealth building.
More importantly, I hope that I described how crippling that incurring debt on non-income generating assets truly is. It’s really a double hit.
Not only do you pay the principle and interest on that item, which may not generate income, but it ALSO deprives you from being able to use these same dollars from creating wealth.
One punch is enough, don’t you think? Now here comes the haymaker. The TWO punch! If the ‘one punch’ is not incurring debt to finance non-income generating assets, then the ‘two punch’ is as follows:
Never overpay for anything especially an asset.
Of course! That is SO obvious! Hold on. I’m not talking about ‘not getting a good deal’ on something like your house. I’m talking about spending too much on something that you really don’t need to spend money on.
Let me drive this point home because it is a major element of wealth building. Yes you ‘may’ need a vehicle to get from point A to point B but does it need to be a brand new Lexus? Could it instead be a 5-year old Corolla? Probably. Sure, you need some form of shelter. We all do but does it need to be a house costing 3 times more than what a basic safe dwelling would otherwise cost? Of course not.
We all need to eat, right? Well of course we do. However, do we need to go out to eat every night funded on our credit card? No.
Do we need to spend $10 or more per meal per person or could we strive to spend $2 per meal per person which is the Financial Independence brass ring? I think we can do the latter and still be well nourished.
Conclusion
Now that you understand the importance of not overpaying for an asset let’s make this as crystal clear as possible. In order to build wealth it is imperative to strive to spend the ‘least amount of money as possible’ in all aspects of your life.
That means paying the least amount possible on a primary dwelling (I would argue to purchase a multi-unit dwelling where you would occupy one of the units in hopes that other tenants would cover the entire cost of the property), a vehicle that is reliable but fully depreciated in value before you purchase it, used furniture, clothes on sale or heavily discounted, etc. I think you get it!
If we can combine the practice of Never use debt to finance an item that doesn’t generate income along with Never overpay for anything especially an asset, we would have created the wealth builder’s One Two Punch!
In effect we now have created our own Sweet Science of wealth!
