July 31, 2014

When You Borrow Money, You Are Renting Someone Else’s Savings

When people talk about “borrowing money”, it isn’t entirely accurate.  What is really happening is renting someone else’s property.  It doesn’t matter if you are talking about credit card debt or student loan debt.

Promissory Note Borrowing Money

When you borrow money, you are renting someone else's savings. Thinking about the economic relationship this way can make decisions much clearer.

Imagine I own a $100,000 lake cabin.  You want to take your family on a vacation this summer, so you approach me and say, “I see you have this piece of property.  I’d like to temporarily take possession of it, for an agreed upon length of time (2 weeks), and in exchange, I will return it in the same shape that I originally found it, plus pay you compensation of $1,500.”  To me, the owner of the lake cabin, we call this compensation rental income, or rent for short.

Now imagine that you want to go to college, buy a car, or purchase a television.  Your personal savings aren’t sufficient to complete the transaction.  You approach me and say, “I see you have some savings because there have been years in the past where you spent less than you earned.  I’d like to temporarily take possession of some of savings, and in exchange, I promise to return it at pre-determined intervals plus pay you compensation each year.”  To me, the owner of the savings, we call this compensation interest income.  

In both cases, you are renting something that belongs to me, promising to return it in the future, and giving me compensation for the time during which I can’t enjoy my own asset.  While you are in the lake house, I can’t take my family there.  While you are spending my savings, I can’t invest it, give it away, or spend it.

How to Think About Borrowing Money 

This brings up an important economic truth: Every dollar you borrow represents someone’s savings. 

On my end, as the person lending an asset, the price I charge you for renting my property depends on several factors:

  • The supply and demand between other property owners and other would-be-renters
  • The rate of inflation.  I am going to want to get paid at least an amount sufficient so that I don’t lose purchasing power each year. 
  • A risk premium.  How much do I trust you?  How confident am I that my property will be returned in the same condition and that you will make good on your promised compensation for using my asset?  The safer I feel, the lower the price I charge.  The less safe I feel, the higher the price I charge.
  • How am I feeling in general?  When people are cheerful, they tend to go along with a lot more than when they are worried, stressed, depressed, or fearful.

On your end, as the person borrowing an asset, you have several factors to consider:

  • What is the total cost?  How much, in annualized terms, am I charging you for renting my property, whether it is a lake house or my savings?  Is the price reasonable relative to other people who are willing to rent to you?  Am I cheaper or more expensive?  Going one step beyond that question, can you afford the price of what I am charging?
  • What do you plan on doing with the property you are renting?  If you own a business and you are borrowing money to invest in the day-to-day operations, what is the return you plan on earning on the capital?  Is it sufficiently large enough over the cost of what I am charging to allow you to earn a profit, compensating you for the risk you are taking?
  • What are the liquidity demands I am making?  Even if the money is cheap, can you afford the liquidity strain that may occur?  Paying back $100,000 is easy if you spread it out over a decade.  It is much harder for most families if you spread it out over twelve months.  Ultimately, bankruptcy is always caused because there is a liquidity problem; at some point, someone who has borrowed an asset cannot come up with whatever repayment they promised.  Many profitable businesses go bankrupt every day.  You can be minting money and still go bankrupt.  It has to do with liquidity.

Understanding this can transform how you view the world and economy.  For people who talk about losing their home to foreclosure, if you rented someone else’s savings to pay the purchase price, and never returned those savings, it was never your home.  You can’t lose something that doesn’t belong to you.  Every dollar represents a claim check on society that some human being, an individual man or woman, has saved for the future.

  • Patrick

    Great article, and a great way to frame the concept of “home ownership”. Whenever someone tells me that renting a place to live is “throwing out your money”, my response is that “buying” a house with a mortgage is the same, only you’re renting money instead of the place itself.

    • peterpatch79

      I agree Patrick. I would say a dozen people have asked why I “pay the landlord” when I could be paying myself by owning. I used to try to provide reasons but they fell on deaf ears, owning would always be the superior option to these people. Essentially the bank owned their house or a fraction of it and could take the house away if they breached their loan covenants but to them it was like they were the king of the castle and I was the dirty rascal.  In addition people tend to underestimate the negative cash flows outside of the mortgage payment like insurance, renovations, repairs, electricity, gas, tax and condo fees which usually add up to 30-50% of the mortgage payment. 

      Up here in Canada our housing market is very hot in certain regions (Toronto and Vancouver especially). The situation is very similar to the U.S. one of 2008 i.e easy money, low interest rates, constant price appreciation creating a sense that prices will only go up. The real-estate  market here looks somewhat bubblelicious to me but that is just pure speculation. 

      • Patrick

        Thanks peterpatch79, I’m in Canada as well (Toronto to be exact) so seeing exactly what you are seeing first-hand. The other huge thing is, here in Canada our mortgages have to be renewed every 5 years. Interest rates are rock bottom right now. If they go up a couple of percent, the magic of compounding would significantly increase the monthly payments to a point where it could become unaffordable.

        • peterpatch79

          Hi Patrick,

          I am also in T.O. what a coincident eh? The condo’s here are growing like weeds, however from what I see a great deal of the buyers are investors looking to make rental income. I think the market will be glutted with condo’s in the next 2-3 years. I am reluctant to buy a home in this city right now due to the high prices relative to median income and the condo mania.

          You can get a 10 year fixed rate mortgage in Canada (http://www.ratehub.ca/best-mortgage-rates/10-year/fixed) but I am not aware of any terms longer then 10 years, although there probably are few of them out there. In addition to the maximum 10 year renewal we also do not allow deductions of interest from taxes like the Americans do. In Canada you would have to do some complicated financial engineering tactic like the “Smith Manoeuvre”, or putting your mortgage in an RRSP to deduct your mortgage interest from your taxes.

           Also in some states they allow people to walk away from their mortgage obligation and the banks can only reclaim the home as collateral. All the persons other assets are protected. We don’t have that either, in Canada the bank will have a claim on most of your stuff if they decided to force a bankruptcy.

  • Suh

    Well you are not borrowing anyones savings when borrowing from the bank but taking out newly created money. 

    • Joshua Kennon

      Even in a fractional reserve banking system, all ultimate credit created through accounting entries is based upon, and referenced back, to the underlying “reserve”. That is, literally, the portion of other people’s savings. Going further, the money that is supposedly created out of thin air is really an extension of society’s savings because the FDIC insurance fees go into a pooled insurance bailout fund that gets tapped. All debt represents the savings (an asset) to someone else.

      If you default on a loan, someone, somewhere had to come up with the money out of their savings, even if it is a fractional reserve system. The only way this could not happen is if you went to a completely deregulated free market system like the one that was present in the late 19th century United States where individual depositors bore the risk of banking at a specific institution. Even then, any money ultimately not repaid is going to be borne by someone else in some capacity, if only it means the grocer raises prices on raisins to offset the bad debt he now incurred from the bankrupted bank owners.

      It really comes back to there being no free lunch. Fractional reserve banking does not exempt one from the rule.