This week we learned that money has a time value-- which is to say that your money is worth more today than at some point in the future. This is because if you had the money now, you could invest it and earn interest (or a return) What this means is that the time value of money is the opportunity cost of foregoing consumption today. This is one of the most important concepts in finance.
We also learned that the future value is the sum to which an investment will grow after earning interest-- and we have and will continue to learn about all the ways interest works. We are also learning that the present value is the value today of a future cash flow.
We can do this analysis. However, when we use these analytical tools to make decisions, does it always guide us to the right place?
I offer that the modern-day crisis in debt has clouded our vision. The ready access to debt (personal, corporate, and governmental) has fostered an environment where the risks associated with debt have been ignored for the preference of consumption today.
To bring it to a personal level, suppose that you could borrow $1,000 on a credit card at 12% interest. You took that borrowed money and invested it in a mutual fund with a 5-year historic return of 27%. Our formulas make you look like a genius. Suppose that your parents could take out a $100,000 home equity loan on their home to pay for your sibling's undergraduate tuition. Your sibling graduates from college and lands a job with the next Google. Our formulas make you look like an uber genius.
The only problem is that LIFE happens. You can't pay the interest on the credit card while your money is tied up in the mutual fund. You can't pay the capital gains on your mutual fund investment because your cash is tied up in the fund. Your parent's house is no longer valued high enough to satisfy the bank's leverage limits, and your parents need to refinance and can't because your father was just "re-engineered" and replaced with a younger worker like yourself who can (and will) work for substantially less. Not to mention the not-so-crazy scenario that your sibling (having money for the first time in his life) is off in Las Vegas with his first paycheck or not inclined to help out because he believes your parents have an obligation to "help" their children.
I happen to like this Ramsey fellow referenced in the clip: http://www.daveramsey.com. Sadly, his radio show is full of tough life stories-- but is also full of hope. Arguably even he would say that his advice is simple and practical-- "God and grandma's advice, but only we keep our teeth in."
Imagine taking these questions to a broader context? How might this balancing act (between fundamental analysis and "life" (really "risk" analysis) play out in corporations or with governments-- rhetorical question?
I challenge you to use what you learn, and then use your mind. Let's talk about what you think.
MSBA511 - Applied Financial Management, exploring our vocations in business with a vision of service to God and community.
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ReplyDeletePROBLEM
ReplyDeleteThe credit card industry shows that we have a consumer deficit in that industry that is surpassing 2.5 trillion dollars. Amazing. That is a large number.
As stated by the video, it is interesting how the banks could easily reduce significant lending risk by simply seeing how their prospective customer has paid their credit card bills in the past, and if that customer has not done a good job with paying such bills, the formula shows those types of customers would be considered a very high risk, and ultimately, a high risk to society. It is an injustice to society for banks to take on such customers. Yet, the place where the banks are making a huge profit in the mean time is by using those customers. Therefore, one party’s profit could mean a loss to many people—a disgrace bearing consequence—example: the economic meltdown. The video states that ultimately, the financial crisis was initiated by the poor financial decisions of a great many American families, individuals who were then taken advantage of by businesses such as banks. Both the greedy businesses and intemperate families point to a FUNDAMENTAL PROBLEM: lack of virtue, which may point to an even GREATER CAUSE of poor upbringing and/or lack of habitual virtuous practices.
SOLUTION PART I
ReplyDeleteFor solutions to these deeper problems, I turn to Aristotle who concisely presents answers and an elaboration of the need for the virtuous life. In the Nicomachean Ethics (IV: 1), Aristotle warns against prodigality, a vice seen in squandering wealth. At least before the financial crisis, our modern American society may not have seen prodigality as a vice, but traditional societies would have always agreed with Aristotle. Aristotle’s warnings against excessive spending are associated with profligacy. The profligate does not care where his money comes from, good or ill, and he does not care if it is spent for bad or good, such as on education or prostitution. And, by spending so much money, he often becomes increasingly in trouble by trying to acquire even more money. Aristotle: “Hence most of them are licentious as well; because spending freely as they do, they squander their money on forms of self-indulgence, and as they do not direct their lives towards an honorable end, they fall into self-indulgence.” Moreover, he warns, "those who have not earned money, but have received the money earned by others, spend it more liberally, because they have not experienced the want of it” and, "that many a prodigal ends in becoming intemperate." In fact, when I researched what Thomas Aquinas had to say on these topics, I noticed that all these quotes were used by Thomas Aquinas as well to support his answers to these themes in the Summa Theologica. Aristotle speaks of the need then to nurture virtuous habits from an early age which will lend themselves to good spending decisions, while pointing to a responsibility found in great part in parents: "Like activities produce like dispositions. Hence we must give our activities a certain quality, because it is their characteristics that determine the resulting dispositions. So it is a matter of no little importance what sort of habits we form from the earliest age -- it makes a vast difference, or rather all the difference in the world" (Nicomachean Ethics, Book II). In Book II, he also shows the place of government in helping a society to progress in this financial direction: "Legislators make their citizens good by habituation; this is the intention of every legislator, and those who do not carry it out fail of their object. This is what makes the difference between a good constitution and a bad one." I see bailouts and understand possible consequences of not bailing companies out, and I do see certain regulations for companies and individuals that were also in place before the economic collapse, but how is the government significantly encouraging this kind of habituation today?
SOLUTION PART II
ReplyDeleteINDIVIDUAL MODERN APPLICATION
In modern times, an example of a form of this same, disciplined, and fruitful outlook toward money-spending is detailed well by Dave Ramsey (http://www.daveramsey.com/new/baby-steps) who lists easy-to-remember baby steps for financial success (that are elaborated upon on that web link): Baby Step #1. “$1,000 to start an Emergency Fund” 2. “Pay off all debt [except mortgage] using the Debt Snowball” 3. “3 to 6 months of expenses in savings” 4. “Invest 15% of household income into Roth IRA’s and pre-tax retirement” 5. “College funding for children” 6. “Pay off home early” 7. “Build wealth and give!” Such steps are one way the disciplined or “the virtuous life” is part of the “pursuit of happiness”.
Well said, Renee.
ReplyDeleteRenee, impressive research and analysis on Professor Carpenter's blog post. I think you're right in the sense that there is a high frequency of lack of virtue in the financial industry, specifically in loaning money. This takes us back to the class Dr. Abela taught on Usury and whether or not it is immoral. Here's the thing, charging a price for money itself is not immoral because as Prof. Carpenter said, "if you had the money now, you could invest it and earn interest (or a return)... What this means is that the time value of money is the opportunity cost of foregoing consumption today" SO essentially, lenders are charging borrowers for the missed opportunity they have of investing that money elsewhere and thus making sure they make a return on investment from the borrowers. This itself isn't immoral but I agree with Renee that charging outrageous interest rates for people who clearly can't pay them can cause huge financial difficulties for a lot of people.
ReplyDeleteBut what about what Professor Carpenter said about "life" happening? What if someone is charged a normal rate of interest and is capable of paying it back with their income but then they get laid off? Is it usury then? Fundamentally, all was fair. "Life" wise, it's totally unfair. I think that in this case, having a safety net and saving money is pretty good advice. It is clearly easier said than done but as I rack my brain about how this type of thing can be prevented for the person, that's all I can come up with. Perhaps I'll have to rethink it a bit more and post back.
There are plenty of things that money can’t buy… but for everything else, there are CREDIT CARDS. Even though credit problems are too big for the feds to fix, legislation is working to get rid of interest-rate hikes on existing balances, ban issuers from putting customer payments toward lower-rate balances, and eliminate raising interest rates because a credit card holder was late paying a bill to someone else. The government is “trying” to offer us consumers some protection. But, credit-card companies are not the only ones we need to be protected from. We need to be protected from ourselves! Every penny of Americans' nearly $1 trillion in revolving debt started with someone. Someone swiped that plastic card because they wanted something. It has been said that money is the root of all evil. While this is a valid argument … in the sense of making money to pay off your credit card debt… and in the sense that stress, anxiety, desire and boredom in the age of consumerism drive us to spend or “swipe”, imagine how much stress, anxiety and arguments could be avoided by simply not using credit cards or taking out high interest loans. Society has this notion that we deserve things and are entitled to things and when there’s a will, there’s a way. CREDIT CARDS are not the way! The obvious solution would be to show consumers exactly how much their credit cards are costing them. But they know… and they continue to swipe! The issue lies with us, as individual irresponsible people in this economically depressed society consumed by consumerism.
ReplyDeleteP.S. Thank Renee for that fantastic argument!
The good thing about debt is that it allows people to obtain things that they would not otherwise be able to. If people were not able to take out loans then the large majority of the country would not have a home, car etc, and most of us would not have been able to attend college. Therefore, debt should not be eliminated completely but it does need to be contained because many people abuse these opportunities taking on way more than they can handle. As Jenna mentioned consumerism is the main issue. But our economy is based on this concept of consumerism. The strategy of every company is to get the consumer to buy more. The real challenge is finding out how to decrease the mentality of consumerism in society, because if this isn't done the debt problem will never be resolved.
ReplyDeleteI think looking at it in a vacuum or looking at the indeed terrible string of consequence, it is incredibly easy to malign this consumerism, credit-happy behavior. And with good reason. The video aptly pointed out the "treacheries of the American financial crisis" which started because of "some personal financial mistakes." I think we're all guilty of this line of thinking - and we're a society that embraces it! As a matter of fact, often times a credit card is required to make certain purchases! So even we chose to live personally as a "debit card" person, we'd have trouble.
ReplyDeleteBut I think Sara is on to something. It is almost as if people make this conscious decision to get themselves into debt for the same of comfort. (Yes, perhaps in some cases this "comfort" is excessive and is better stated as luxury, but often times not). Of course, we need to exclude the people who are losing homes because of this mentality - I think that's a story in it of itself. But when we deal with people relying too much on their credit cards or perhaps yes getting that new car or something big, I think that they are ok with the consequences because it brings them that happiness. It's that - American happiness. And it's almost just as American to be in debt and complain about the late fees or worry about the statement. I recall an episode of "It's Always Sunny in Philadelphia" (a silly comedy with characters with no regard for consequences) where they kidnap a Mexican family to fulfill their slapdash version of "Extreme Makeover: Home Edition" in their own misguided sense of altruism (with a secondary goal of integrating them into the country). They steal the family's credit card and go crazy at a local Home Depot. When one character musses on how any of what they are doing at the Home Depot will help the family integrate to the US, another character quips, "what's more American than debt?" I think there's something to that. Americans have this concept that their debt and getting into debt to maintain their own idea of a comfortable lifestyle is the American thing to do - and quite ok. And you know, extreme examples aside, there is value in that. We read little chain letters or hear from seminars the secrets to financial success through savings - which we reap the benefits in like 30 years or more. But for many of us, we'd rather enjoy the now, with what we have, instead of banking on a future that we not only are too impatient to wait for, but very well know there are no guarantees.
So as Sara suggests, there needs to be a mentality tweak - because so many of us are entrenched with the belief that a little but of debt is a small price to pay for a lifestyle they covet. Of course, we're seeing how "a little bit of debt" can snowball into - well, a treacherous financial crisis. But we as Americans are an impatient, optimistic people, and we tend to hate waiting and expect the worse.
Sara, I like your point that obtaining debt does have positive outcomes. The majority of people need a mortgage or student loans in order to live well. Many times "debt" has a negative connotation, but we must be realistic and understand its benefits. Unfortunately, this connotation comes from the many people who abuse debt--Those who do not pay off credit cards or who spend freely in other areas of their lives when saving should be more of a priority. My question is, who's responsibility is to decide if a person should get a loan? Banks are supposed to perform background checks on people seeking loans, but as the video showed, certain people are actually targeted to receive sub prime loans. Everyone must take responsibility for his/her actions. If there was a higher power constantly deciding whether or not one could do something, life would be awfully pathetic. It's time people were educated about loans and personal finances so that they could make reasonable decisions.
ReplyDeleteMeredith, you are absolutely right about taking personal responsibility for one's actions. There are so many aids to reduce avoid dangerous debt; academia, books, TV shows, family advice, etc. However, this issue has two faces; the consumer and the financial institution.
ReplyDeleteThe economic system in this country is such that without a credit history (and a credit card) the purchasing power is drastically reduced. It is necessary to buy or rent a car, an apartment, a house, or get a loan. It would not be an issue if both sides were virtuous, unfortunately we exhibit greed and envy which are the root cause for the economic downfall.
Unfortunately, no one overseeing group is perfect, and who will monitor the monitors? The only solution is that individuals first behave responsively, also there needs to be at least one person speaking up when a decision is unfair or vicious. As debt is a necessary tool to create wealth, accountability is the instrument that will progressively stir us back to light and out of the red.
Debt is catch 22 scenario. As some students have pointed out going into debt (or situations where loans are required) can reap positive outcomes such as a college education or buying your first home. However, scenarios where one chooses to go into debt because they cannot ‘live’ without the J. Crew cashmere sweater is just wrong. I agree with Jenna that credit cards are not the answer. I’m 22 years old and have absolutely no debt. I owe no student loans (thanks to my family members) and I do not own a credit card. I operate on a cash basis only and I believe people should NOT spend what they don’t have. With that being said, I do not agree with Anna’s statement on how debt is a ‘necessary’ tool to obtain wealth. Yeah- a college education will provide you with a job, but how long will loans last after that job begins? A friend of mine—who I recently saw—is a teacher. She said she loves her job and believes her undergraduate (private school) degree prepared her for her job BUT she has come to the realization that she will be paying back her college loans for the rest of her life. Where’s the wealth?
ReplyDeleteUnfortunately, the federal government and I don’t share the same debt ‘philosophy.’ Clearly, one’s personal finances differ from those of a nation; however, if a little bit more responsibility and less frivolous spending were instilled, the U.S. might be in a better financial state. I hate to sound like the pessimist, but I do not think the federal government can save themselves from this financial crisis. We are in trillions of dollars in debt and some economists believe the U.S. dollar might become China’s Yuan. Remember what Professor Kirst said? Learn Chinese!
I think on a whole financial institutions need to be more transparent and accountable. Like others have pointed out, what is the deal with the monitors? And who is qualified to allow such financial transactions? I believe there can be an overlap between the federal government’s finances as well as our own. I mean we pay them taxes, right? I just worry some financial institutions are beyond repair.
I also believe that credit cards are a blessing and a curse. More so a curse. It brings people under the illusion that they can afford something that they really can't. It foregoes the notion of saving up your money so that in the future you can make that big purchase by bringing the purchase to reality now while not having to worry about paying until later. For some this is beneficial but to others it is a very dangerous hole to fall into. It comes down to a person's financial responsibility. Those who actually work for their money and know where its coming from and their need to depend on it usually have a better sense of taking care of a credit card. Those who are used to everything being handed to them and never had to take responsibility for things tend to be less responsible. It all falls down into the materialistic world with the ideas 'I want it and I want it now" which just isn't a possibility for everyone. People need to take ownership of their earnings and be responsible with them. With the help of credit checks, etc we can limit the amount of debt that people will fall into but not completely. It comes down, as Meredith said, to education about loans and credit cards and understanding of their purpose to society.
ReplyDeleteThis post actually makes me think of a couple months back while reading cnn.com, I came across an article in the personal financial section with the heading First Premier Bank removes credit card with 59.9% APR. My first instinct is, of course, they removed it! Who in their right mind is going to use a credit card with 59.9% APR! Upon reading the article the card wasn’t removed because of no one wanting it. No, it was removed because too many people wanted it! “The 59.9% card, which had nearly 300,000 active customers as of early February, charged more than $100 in fees per year and typically extended a credit line of about $300.” What’s crazier than using this credit card??? How about the bank originally offered the credit card with an even higher rate of 79.9%! Guess who these crazy credit cards are geared to…you got! People with bad credit! Beacom, First Premier CEO, said the card serves a growing need for customers with less than perfect credit.
ReplyDeleteSo who’s at fault here? The banks who take advantage of the situation or the people who let the banks take advantage of the situation? To solve these issues, people need to be informed about what is going on at a young age so that they don’t get pulled into the situation when they’re older. I believe all children at a young age should have personal finance courses integrated into their high school or maybe even middle school curriculum.
According to www.creditscards.com, the average credit card debt per household with credit card debt is $14,750 and over 609.8 million credit cards are held by US consumers. 609.8 million?? The population of the United States is only 307 million including children under 16 who don’t typically have credit cards. So why do people need so many credit cards? I think a part of the problem is society and the practices the businesses use. For example, at Enterprise it is much easier to use a credit card then a debit card or money order. Checks, you say? We politely decline most checks. Using a credit card reduces your deposit amount and you don’t have the hassle of bringing in other documentation like a pay stub or utility bill to qualify for rental.
But is debt bad? For most people, yes. For students who without debt could not attend college and in turn get a better job. No. Debt is not always bad. I think is truly depends on why the debt is accumulated. If you’re going to school to get a better job with a better paycheck, then no, debt is not bad as long as you can afford it. Accumulating debt because you want the newest car, the most stylish clothes, and the coolest vacations is wrong and will come back to haunt you.
If you want to read the cnn article I mentioned, the link below will help.
First Premier Bank removes credit card with 59.9% APR
Debt, debt, debt, and more debt. This is a common theme amongst American’s today and it is inevitable. The cost of tuition for the current MSBA class of 2011 is $34,000. The majority of us do not have this amount of money in our bank accounts to pay for school, so we had to look into taking out student loans. Our loans we took out in order to finance our education was approximately $34,000. This is only for the cost of tuition; this does not include books, travel expenses, rent, etc. For the year, the MSBA student is looking at spending $65,000. This is a lot of money, and the majority of this is financed through loans. This large number looming over a 23 year olds head is a massive burden; however, debt in today’s society is encouraged. In order for the MSBA student to obtain such a large student loan, they had to have a credit check. Without a good credit score, obtaining approval for the loan would not occur, and the majority of us would not have been able to join the program.
ReplyDeleteNow, another question arises, how did we achieve a good credit score to approve for the loan? We were already in debt! How did we obtain approval to move into our apartments, we had a credit check! If you were to rent a car to go around the city, we had a credit check! Credit is something that is always looming over our heads and we are always worried about. However, we know that if we are responsible, we will have good credit and have more opportunities in life. Having a bad credit score can even close doors on possible future job opportunities.
Credit is something that is always looming over us and we are learning how to balance every day.
Like most things in life, the acquiring of debt is something that requires good judgment. The obvious example that comes to mind is this program. Obviously for some, the ability to pay the entire tuition amount is an unrealistic expectation for several of us. We would need to look at the taking out of a loan as an investment. It’ll pay off down the road but that’s only after we have agreed to a contract in which the debt will have interest added on.
ReplyDeleteNow if someone is taking out loans left and right and there is no real thought towards it being an investment that will eventually be paid off, then that demonstrates little more than “bad” judgment. There are certain things in life that are necessary towards the advancement of one’s personal and professional life. One of these things will be the acquisition of certain amounts of debt to finance certain ventures that will benefit at a later time.
With that in mind, it is a fact of life that businesses will have to take out certain loans and acquire certain risks for the longevity and success of their business. But this must be done prudently (and probably sparingly).
I personally am a huge fan of Dave Ramsey and I take his mantra (“Live now like no one else so later you can live like no one else”) to heart. I only acquire debt when it’s unavoidable and when there is a reasonable expectation to not only pay it back but also that acquiring the debt will profit me in the long run. His book is pretty humorous and I realized while reading it that I already practiced several of the quirky things he suggests. I rarely purchase something that I don’t need (not really a big impulse purchase person). I never use my credit card (I know, I’m strange…I actually have it stashed in the freezer—only to be used for an emergency). And I balance the cost of keeping my car alive with trying to finance a new one.
Debt and credit cards are not necessarily “bad” things but they too often can be used imprudently. Like everything else that I’ve posted on this site, it is something that should be preceded by good judgment before it should be put into practice.