Written by Mike Summey
Almost every day you read articles or hear commentators talking about the sad state of our country and how the gap between the rich and poor is widening. Have you ever wondered how wealth transfers?
I know, the mainstream media and many progressives blame it on big business and Wall Street tycoons. That may be the end result, but it’s not the reason wealth transfers from the poor to the rich. I’ve written about this before, but I’m taking a slightly different approach this time. I submit to you that there is only one way that wealth transfers—through debt.Consider this example:
Suppose you and I work the same job at the same company and make the same amount of money. We live in houses that cost the same price. The only difference between us is that my standard of living only requires 80% of my take home pay and I invest the other 20%. You, on the other hand, live a lifestyle that consumes all of your income each month. For this reason, in the beginning, you will always appear more successful than me. You will probably drive a nicer car, have more expensive clothes, take more vacations, and spend money on high-priced “toys.”
One day, you find a really nice boat that you would like to have, but you don’t have the money to buy it. In the past, when you’ve asked why I didn’t do things your way, I’ve told you I’ve been saving my money. You are aware that I have a sizable amount saved, so rather than going to a bank, you ask me if I would loan you the money to purchase the boat. You offer to pay me 10% interest on the money. I trust you and 10% is a nice return, so I agree to do it. We have a note and security agreement prepared that gives me a lien on the boat as security for the loan. Everything is done in the same way it would if you went to a bank.
You buy the boat and begin making payments that include the 10% interest. Everything works great and eventually you repay the loan in full, with interest. During this time, you look like you are doing much better than me because, in addition to all the other things you have that I don’t, you now have a boat, too. Our friends and coworkers wonder how you can be doing so much better than me when we both work the same job and make the same money. They might think I waste my money because they cannot see how I have spent it. But during those early years, I lived a more frugal life, saved money, and prepared for a better future.
Let’s analyze the transaction that has occurred between us. We both worked the same number of hours for same amount of money up to the point when you borrowed the money for the boat. Prior to then, you spent all of yours, but I didn’t, which is the reason I could make you the loan in the first place. Just for ease of calculation, let’s assume the loan was for $10,000 and you paid me a total of 10% interest, for a total payoff of $11,000.
Here’s where the wealth transfer occurs. We both worked the same number of hours to earn $10,000, but you had to work additional hours to earn the extra $1,000 you paid me in interest. Since we both make the same rate at our jobs, if I work the same number of hours you have to work to earn the $1,000, I will have an additional $1,000 plus the $1,000 you pay me. At this point, I will have $2,000 more than you for the same number of hours worked. The $1,000 you paid me bought you nothing, but it will buy me anything I choose. Rather than saving to buy the boat, you chose instant gratification and were willing to pay $1,000 more than the cost of the boat so you could have it quicker.
The cost of interest made me a bit richer and you a bit poorer. This example may be an oversimplification of wealth transfer, but when you apply this concept to the trillions of dollars worth of debt in this country (personal, city, county, state, and national), is it any wonder the rich are getting richer and the poor are getting poorer? After all, money isn’t borrowed from the poor; they don’t have it to loan.
Let’s go a step further. Suppose you were willing to save enough money to buy the boat over the same number of months it took you to repay the loan. Again, for ease of calculation, let’s assume you earned a total of 5% on your money while you were saving. 5% of $10,000 is $500. By saving first, you would still have the $500 your money earned after paying $10,000 for the boat. That’s $500 you would not have had to work and earn. The net result is that by saving first, you would only have had to work and earn $9,500, not $11,000. The $1,500 difference is the price of impatience…of having an “I want it now” mentality.I believe the average American pays enough in interest and finance charges over their lifetime to become millionaires.
“But,” you say, “don’t you need money to make money? And, if you don’t have it and you want to make it, don’t you have to borrow money in order to do so?” The answer is yes, but only if you can put the borrowed money to work in a way that earns more than it costs to borrow. Banks are a perfect example. When you deposit money in the bank, the bank treats it as a loan; after all, it’s your money. You expect to get it back and, in most cases, you expect the bank to pay you interest or provide some service in exchange for the use of your money. The bank then loans the money to others and charges them enough interest to provide the bank with a spread between what it pays you and what it charges those who borrow it. That spread, minus the cost of doing business, is the bank’s profit, which is either used to grow the bank or is paid to the shareholders who own it.
I used banks in this example because the way they operate makes it is easier to understand. There are many ways in which other people borrow money and use it to make a profit. Personally, I borrow money from banks and invest it in properties that rent for enough to pay back the banks, and provide me with a profit over and above what the money costs me to borrow. The same holds true for many other types of investments, whether they are operating businesses like restaurants, manufacturing companies, service industries, etc., in which one can invest borrowed money and earn enough to repay the loans and make a profit.
Naturally, the biggest returns come when you can invest your own money and not use borrowed funds. It cuts out the middle man. In the earlier example in which I theoretically loaned you $10,000 to buy a boat, I would not have made as much if I had borrowed the money from a bank and paid 5% interest on it. Then I would have only made 5%, which is half of the amount I made using my own money. A good rule of thumb is to not increase your standard of living more than what the amount of money from your investments will support.
Now, back to the subject of why the rich get richer and the poor get poorer. When money is borrowed to buy things that don’t earn income, or spent on things that are consumed like dining out, concerts, vacations, etc., wealth transfers. Another good rule of thumb is to consider any debt that must be paid from your earnings as helping someone else get rich at your expense. One exception is a loan on a reasonable house in which to live, one that is considered reasonable based on what you earn. It’s reasonable because you have to pay to live somewhere. You will either make payments on a home loan, or pay rent to someone else who owns the property where you live.
The real killer is consumer debt like credit cards or loans to finance campers, boats, RVs, planes, big screen televisions, etc. These are things that many people buy in order to give the appearance of wealth, for which they have to borrow money to buy. Our country is drowning in an “I want it now” mentality. People ask themselves: “Can I make the payments?” not “Can I afford the purchase?” If you choose the short-term satisfaction, others get rich at your expense.
Following WWII, debt was encouraged as a way to keep the economy growing. Interest, even on consumer debt, was allowed as a tax deduction. As a result, our country is covered in debt. However, debt no longer carries the stigma it did following the Great Depression. At the time of this writing, our national debt alone is approaching $19 trillion. That doesn’t include state and local governmental debts, which are at an all-time high. Consumer debt and student loans are in the trillions of dollars. How long can America’s obsession with living beyond its means be sustained? Or should I ask, how rich will the wealthy become before the poor go completely broke?
If your “I want it now” mindset is causing you to spend more than you make, you only have three options: spend less, earn more, or go into debt. Going into debt is the easiest option in the beginning, but doing so will eventually force you into one of the other two options. It’s a fact that holds true not only for individuals, but government as well. There is always a point at which lenders will refuse to continue loaning money and this is true whether it is to you as an individual, or whether it is a company or government entity. Believe me, unless we rein in our overspending habits, there will come a day of reckoning and it won’t be pleasant.
As debt grows, so will the gap between the rich and the poor. Income redistribution is not the answer. I would be willing to bet my life that if you could wipe the slate clean, eliminate all debt and start over with everyone having exactly the same amount of money, within a single generation, those who are rich now, would be rich again, and the ones who are poor now, would be more likely to be poor again. That’s because some of those who are poor, are poor because of the choices they have made, and those who are rich, are rich because they have made different choices.
Taking from the rich and giving to the poor will not change this. All this does is reward some people who opted for instant gratification and provide little incentive for them to change. If you don’t believe this, just ride through any of the government housing projects that were allegedly built to give people a hand up. With all the trillions spent since Lyndon Johnson’s War on Poverty began, we still have just as much or more poverty today than we did back then. One very noticeable difference is changes in the work ethic of people who live far beyond their means.
So, before you start railing about the widening gap between the rich and the poor, take time to analyze why it is happening. I think you will find the same thing I did. Wealth only transfers through debt and our present situation is the direct result of an entire society trying to live above its means by choosing to go into debt. Unless we curb our appetite for a lifestyle we cannot afford and begin paying off what we have already consumed, we are headed for an inevitable collapse in our economy. This is not a scare tactic, it is just plain common sense.
To learn more about the tools for financial success and how to avoid debt, read Mike Summey’s latest book, “Financial Security Bible: How to Build Wealth and Be Happy.” Currently available at Audible.com, the hard copy arrives in fine bookstores everywhere in November.
Mike Summey is an entrepreneur, author of several books on real estate, and also an avid pilot and philanthropist.