Loans & Debts – this is how it works, so your finances are affected.


What is wealth?

What is wealth?

First, let’s see how to define “wealth”. Even if you are not rich, you always have a certain wealth, and that is something we must keep in mind when we talk about loans and debts.

Definition: Assets = Assets – Liabilities

If you count everything you own and subtract from everything you owe, you get a number called your wealth. If all you own is a hundred bucks in your wallet, well then this is your wealth – a hundred bucks. And a wallet.

But let’s take a look at a more realistic example.

Examples of wealth

Say you have saved five thousand dollars in your bank account. You have a thousand USD donor in cash, distributed on the trouser pocket and chest of drawers. You owe five hundred USDonor to a friend after the last expiry. What is your fortune?

Assets: USD 6000
Shoulder: 500 USD
==================
Wealth: USD 5500

Now let’s see how your wealth is affected by various events, like taking a loan or buying a bike.

A loan does not increase your wealth

How do you think your fortune is affected by taking out a loan? You might be dazzled by the sounding coins and think you can get rich from borrowing? Or you may be intimidated by the debt and think the loan will make you poor? None of the alternatives are right, wealth is unchanged.

Suppose you borrow a thousand dollars from another friend. Before you take out the loan you have a fortune of USD 5500: six thousand USD in assets minus five hundred in debt.

What do your assets and liabilities look like after the new loan? Yes, like this:

Assets: USD 7000
Shoulder: 1500 USD
==================
Wealth: USD 5500

Sure, you’ve increased your assets in sounding coins, that’s right. But at the same time you have increased your debt by exactly the same amount. So the loan itself does not make you richer or poorer.

So how do you go about reducing your wealth? Is it when you shop? No, it does not affect wealth either. Strange huh?

A purchase does not diminish your wealth

Say you buy a bicycle for two thousand USD donor. Then you’re probably two thousand USD donor poorer then? No, not actually.

Certainly, you now have two thousand dollars less in your bank account. But in exchange for them you’ve got a bike. And what is the bike worth? Yes, two thousand USD donor. By definition. Because that’s what you paid for it.

The bike is an asset. Your fortune still looks exactly the same.

Assets: USD 7000
Shoulder: 1500 USD
==================
Wealth: USD 5500

“Well, what good, then you can borrow and trade exactly how you want, if it does not affect wealth?” You may be thinking. Wrong.

Because after you take out the loan, and after you buy the bike, your wealth will start to shrink. A little at a time and so slowly you may not even notice it. But one day you will notice.

So how do you do when you become poorer? What is happening? Well, both gadgets and debts are related to certain costs.

It costs to own things

It costs to own things

After a year you may want to sell the bike to get some money. Some assets are so difficult to trade for. Then you can change the bike’s value for money again without affecting wealth, right?

That’s right in a way. But still not. When you sell the bike you will not get back as much money as you bought it for. The cycle has decreased in value.

Let’s say you get a thousand bucks for the bike. Then your wealth has decreased by a thousand USD honor during this year, just through the passage of time.

For each passing day, the value of your gadgets decreases, and your wealth decreases at the same rate. Then of course there are other costs, such as repairs and maintenance and maybe a fee for parking or bicycle storage, a new bicycle helmet and so on.

All these costs reduce your wealth on an ongoing basis. But then there is another effect that is more difficult to see. Not exactly a cost, but almost. By buying things, you refuse to let wealth grow.

Cost of missing interest

Cost of missing interest

Owning things has a different kind of cost, which is not an actual cost. It is usually called “alternative cost”.

Because you exchange two thousand USDonor for a bicycle, you can not have that money at the bank anymore. And thus you will not receive any interest for them.

Missing interest is not really a cost, but it is an absence of income. You refuse the interest you would have received for the money if you had not traded for them.

Now you may be thinking that there will still not be much interest on two thousand USDonor. Again you are right, but still not. If you put two thousand dollars in the bank today, the return may not be that great in one year, that’s true.

But if you then deposit the return on the account and allow another year to pass, then the total return after two years will be more than twice the size after one year. If you continue to do so over the years, capital grows through interest on the interest rate effect.

Every time you make money, you forgo interest on interest on that money for the rest of your life. It actually makes a certain difference in the end. Especially if you plan to live long.

It costs to have debts

It costs to have debts

We saw above that your wealth is not affected when you take out a loan. That is true, but unfortunately it is not the whole truth. A loan is always associated with certain costs, and costs always reduce your wealth.

During the term of the loan, you will pay interest, usually once a month. The interest rate is a cost. It is money that disappears from your wealth and never comes back.

Often there is also a fee to be paid for the loan, perhaps even when you take out the loan, or regularly during the loan’s term. We will see how interest rates and fees affect your wealth.

Examples of interest and fees

We return to our first example. You have assets of USD 600 and a debt of USD 500 that you borrowed from a friend.

Now you may not usually pay interest to your friends, but let’s assume that your friend is a little businesslike. She wants ten USD in fees each month for the duration of the loan, as well as ten percent of the loan amount in interest. Reasonable or not, it was your deal that you agreed to that night.

She might not really want to lend money to a good friend, but you persuaded her? (Or you can imagine that this is an SMS loan.)

This means that your assets decrease by USD 60 every month. The debt, on the other hand, is unchanged, thus reducing your wealth, as we shall see.

After four months you have paid USD 240 in interest and fees, and your wealth has decreased by the same amount. (We pretend nothing else is happening. It is unrealistic, but it is to set a clear example.)

Assets: 6000 – 240 = 5760 USD
Shoulder: 500 USD
==================
Wealth: USD 5260

As long as the loan is running, your wealth is constantly decreasing with the cost of the loan. Doesn’t it feel good? Well then it might be best to start paying off the loan!

A repayment on a loan is called “amortization”, and although amortization is money to be paid out, there is no cost. How is it related? Hang on and we’ll see.

Amortization is not a cost

Amortization is not a cost

That is a saying that all the wizards love to throw away. Yet it is true as they say. How can it pay off?

Again we look at how your wealth is defined. Before you repay it looks like this:

Assets: USD 5760
Shoulder: 500 USD
==================
Wealth: USD 5260

Then you pay a hundred bucks on the loan. Your friend will be happy but you will feel poorer. And it is true that your assets have decreased by a hundred USDonor, but your wealth is still unchanged. 

Assets: USD 5660
Shoulder: 400 USD
==================
Wealth: USD 5260

Your wealth is unchanged. You have reduced your assets, but you have also reduced your debts. It’s just like when you took out the loan, but on the contrary.

What good is it then, if it does not affect wealth? Well, now the loan will cost a little less each month. Your wealth will not decrease as quickly. It is good.

The interest rate of ten percent is now USD 40, as the debt has fallen to USD 400. With the fee of USD 10, your monthly cost will be USD 50 instead of USD 60. 

Why borrow money if it costs?

Why borrow money if it costs?

Now we have seen that both consumption and depreciation and loan interest rates and fees cost money that will disappear from your wealth forever. With interest on the interest-rate effect, the amount that you could have had, but which you have now renounced, is constantly growing for good.

Question: Why should you buy things and borrow money at all? 

Answer: Because there are values ​​in life other than economic values.

Eating has a certain value. Having clothes and a roof over your head has a value. Going to the cinema or going to a concert or reading a good book has a value.

These are not values ​​expressed in USD onor and penny, but in something else. In prosperity, well-being, meaningfulness. Good luck. But the values ​​do exist just because we are so happy to exchange our money for them.

It costs living, simply. And life is not about who is the richest when you die.

In addition, you can sometimes get a return on the money you borrow. For example, if you borrow money to study, you may raise your salary quite significantly for many years after studying. You can recover the cost of the loan by a wide margin.

So it doesn’t have to be wrong to take out a loan. But the loan entails costs, and one must understand how it affects one’s personal finances. Hope this article has increased your understanding a bit, but there is much more to read.

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