Of Borrowing and Saving

The basic rule is, if you are not already saving, then you are not ready to borrow. This may sound paradoxical, but it is the only safe way to approach borrowing.

You may wonder, if I have savings, then why would I borrow? That question may be answered in any number of ways. Asking it suggests some lack of understanding of the proper purpose of borrowing.

The proper purpose of borrowing is to manage your income. You should never borrow to spend beyond your income.

Most people receive income in lumps, like once a month or twice a month. Expenses do not always behave themselves that way. First, there are the every day expenses, such as for food, transportation, and a wide range of miscellaneous minor expenditures that quickly add up. Then there are other expenses that occur monthly and may more or less happen at about the same time as your income. A third category is the big expenditure, that may come once or twice a year, such as tuition, taxes, major purchases, insurance premiums. Since the timing of our income and outgo often do not line up, we use borrowing to help bring the two into line.

For example, the tuition is due in September, but you plan to pay for college by working through the school year. A student loan or other borrowing arrangement with the college can line your income up with the expense.

Another example might involve a big appliance. Your refrigerator breaks down and you need a new one. You may not usually have several hundred dollars of unallocated income available in any one month to pay for the new refrigerator, but you likely will over the course of a year. Borrowing lets you draw that income from the course of the year into your current month and match it against this large purchase needed today.

Here is a bigger example. You need a new car, both for family transportation and perhaps even for travel to work. Very few people have enough ready income to buy the new car with what will be received in any one month. Most people, though, can draw upon funds available from their income over the course of a few years to pay for the car, and borrowing is the tool that they can use to do that.

Of course, this borrowing from the future to pay for something today can be abused. There is a natural temptation common to man to seek gratification today and worry about tomorrow’s problems tomorrow, even while causing them today. Two things can help counter this potential for abuse. One is interest, and the other is saving.

Interest is what we pay for borrowing. While rewarding the lender, it is a penalty against anyone who borrows in order to spend beyond his income. As you spend beyond your income, the interest mounts. In the end, it will bring down the abuser once the abuse has gone too far and gets out of hand.

Saving is a more benign and effective check on the impulse to borrow in order to spend beyond income. If you are regularly saving, you are doing something even more important than preparing for the future and reaping the rewards from lending to other borrowers. By definition, if you are saving, you are living within your income. You are taking part of your income and putting it aside. That discipline is what is needed to prevent you from using borrowing to exceed your income. You have a proven practice of spending less than you earn.

That is why I say that if you are saving, then you are prepared to borrow, and if you are not saving, then you are either living right on the edge—spending your income as fast as it is received—or you are going beyond, borrowing to spend beyond what you earn, and that leads to trouble. Then you will be spending to consume something that you did not earn and do not deserve. The eventual price for that is loss of freedom, as you must in the future consume much less than you earn in order to satisfy the debts.

(First published September 8, 2008)