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For most people, Debt is a bad word, a necessary evil they have to live with but strive to eliminate from their lives entirely. In fact, people go so far as to celebrate when they’ve eliminated all their debts. It’s understandable, being debt-free represents freedom in so many people’s eyes; freedom from the risks of job loss or other financial difficulties. This sounds great and all, but you will never get rich without using debt to your advantage. Let me say that again,
You will never get rich without using debt to your advantage.
Paying off all your debt may give you a warm, fuzzy feeling inside, but unless you plan to win the lottery, it’s never going to make you rich. Don’t get me wrong, I’m not saying I’m a fan of credit cards or auto loans or even student loans; what I am saying is that all of these things, when used properly, can help you build wealth. I’ll cover these in detail in the future, but one aspect of debt I’d like to talk about here is,
Debt is a hedge against inflation.
Investopedia.com defines hedge as, “Making an investment to reduce the risk of adverse price movements in an asset.”
So, debt can work to reduce the risk of adverse movements of inflation. To illustrate, what happens when inflation is on the rise? Your money is worth less than it was in the past, so your $50 in the bank today is worth less than $50 tomorrow. With me so far? Doesn’t it make sense then, with inflation on the rise, that your $50 in credit card debt today is worth less than $50 tomorrow
An Example
The Fed tries to keep inflation around the 2-3% per year mark, but let’s say, for the sake of illustration, that inflation is eating away at the value of your money at the mind-blowing rate of 50% per year; that means a $1 pack of gum today will cost $1.50 next year. Now, let’s assume you have $10,000 sitting quietly in a savings account at your local bank. You also have $10,000 in credit card debt. To keep things simple, let’s assume you aren’t making payments on the credit card debt, so it remains at a balance of $10,000. Also for the sake of simplicity, let’s eliminate interest, both on the credit card and on your savings account - I can picture you grinning from ear to ear already! So, a year from today, at 50% inflation, the $10,000 in your savings account will only get you $5,000 worth of stuff. Aren’t you glad inflation isn’t at 50%!? However, you still owe $10,000 on your credit card, and that’s subject to inflation as well. Here’s the best way to think about what happens to debt as a result of inflation: Imagine you’re back in 1900 and you owe someone $500; you wouldn’t be too happy because, according to the Datafiles of Historical Prices and Wages, that’s what an engineer made in 5 months of full time work. Fast forward to today, the fact that you owe someone $500 may not be a big deal because that $500 doesn’t have the same value it did before inflation took its toll. Granted, that’s 100 years of inflation, but the principal holds true in our example. At 50% inflation per year, the $10,000 you owe is only worth $5,000 to you next year, in terms of what you can buy with that money.
Can you see where I’m going here? In our simplified example, both your savings and your debt are affected by inflation equally, so there is no inflation-adjusted loss in net worth as a result. Now consider what would happen if you had $10,000 in the bank and no debt. After our year at 50% inflation, your $10,000 can only buy you $5,000 worth of stuff, but you don’t have any debt to hedge against the inflation, so your inflation-adjusted net worth decreases by $5,000.
A Note On The Simplicity of This Example
Keep in mind, the previous example does not include credit card or savings account interest. It also does not include the fact that your credit card requires minimum payments, which act to reduce the balance over time. When you consider these factors, the equation changes, but when used properly, debt is a great hedge against inflation.
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