Rich and poor both use credit. Poor need credit while the rich have mastered the game of credit. For them, credit means leverage, tax benefits, and liability insurance.
A few days back, I had posted ‘Why did I refinance my car loans today‘, I had someone ask me “Oh, so you went into debt with 2 cars” -> That is what prompted me to write this post.
What is Credit?
Let us first define what do we mean by Credit -> Credit is any form of borrowing. The most common forms of Credit include credit cards, student loans, auto loans, and mortgage.
Everyone uses Credit, the poor as well as the rich. At first it sounds ironical – why would someone rich borrow money (use credit/ go under debt). Well, read on, and by the end of this post you will know why?
The image conceptually represents what I am trying to say – poor use a large proportion of credit lines available to them. The middle class tries to minimize the use of their credit lines, and then the rich again try to use as much credit as possible.
This chart is more conceptual, we will make a couple of minor tweaks to it as we develop this post today.
Why do Poor use Credit
Poor live on credit because they are not able to make the ends meet. They have credit card debt that either accumulated over time or was a result of some unforeseen circumstances (medical expenses for example).
The middle class, in my opinion, uses the least credit. And that is the right thing to do for them. Using credit even when you do not need it is a game best suited for the rich or the middle class who understands the game that the rich play.
Credit card debt is bad, very bad for your financial health. The middle class should spend only as much on the credit card as they can pay off in full every month. This keeps developing credit history in addition to earning reward points.
Do not underestimate the amount of rewards points you can earn. Many credit cards out there offer 1.5% in cash back. For someone who spends $1,000 every month, that is $15 per month, $180 a year, and $900 a year. And all this for just paying by your credit card in stead of debit card.
Rich play the game of credit
Rich have all the money in the world. They could afford to buy cars and houses by paying cash but they do not. They try to live on credit as much as possible, for 3 reasons – leverage, tax benefits, and liability insurance.
Credit provides Leverage
Leverage enhances returns. Let us take an example:
Let us assume a hypothetical scenario – a house costs $50,000 and pays a rent of $1,000 per month. A rich person who has $500,000 to invest in real estate can buy 10 houses and earn an income of $10,000 per month, or $120,000 per year.
Now if the rich borrows money to buy houses – he puts down $500,000 and borrows an additional $2,000,000 from the bank. Now the rich has a total of $2,500,000 and he can buy 2,500,000/ $50,000 = 25 properties.
These 25 properties will pay him $25,000 per month in rent, equaling $300,000 per year. The rich person has to be interest rate to the bank, say 5%. 5% on $2,000,000 is $100,000. After paying interest the rich has $300,000 – $100,000 = $200,000 remaining as compared to the $120,000 he had without the loan (leverage).
“Give me a place to stand and with a lever I will move the whole world.” – Archimedes
You can read here why I think leverage is a more powerful tool in real estate as it is in the stock market.
Credit provides Tax Benefits
With the help of CPAs and tax attorneys, the rich have devised sophisticated strategies. Sometimes they are very simple and sometimes they can be quite complex. Many a times, they include writing off the interest payment as an expense. Let us take a couple of examples from real life:
Tax shield for the self employed
Someone who is self employed: He or she can deduct the car interest expense to the extent the car was used for business purposes.
Mortgage interest on primary residence is tax deductible. So a mortgage interest rate of 4% for someone in the 25% tax bracket effectively is costing them only 4% (1-0.25) = 3%.
(Note: The mortgage interest deduction gets phased out at high income levels – at incomes higher than $254,200 for singles. Still this example is good for illustrative purposes, the rich use tax shield through their corporations too).
For poor – 100% of their AGI (Adjusted Gross Income) comes from salaries and wages.
For the rich – For a typical rich taxpayer who makes less than $500,000, salary accounts for 75% of the AGI. The corresponding number for $500,000 – $1,000,000 is just over 50%. This number drops to 15% for those making $10 million or more a year (85% of the AGI comes from capital gains, dividends, and business income).
Borrowing on margin
I have heard people saving for the down payment for their primary residence. If you are a little more astute (and have a long time horizon), you would rather invest in the stock market and sell the stock when you need money for the down payment. Isn’t that what the rich do?
NO – the rich will not sell stock, they will borrow on margin against the stocks, make a down payment, and write off the margin interest as investment expense!
When do people get sued? Not when they are wrong but when they have something to offer as a result of a lawsuit. Even IRS pursues only those cases where it finds a reasonable possibility to collect taxes. For the rest, it will stamp your file as CNC (Currently Not Collectible) and suspend all collection activity and release any levy.
Similarly, the rich get sued because they have the assets. But when all the assets are bought on credit, the rich own nothing, it is the creditor (bank) who owns everything.
The rich use a host of other and probably more effective asset protection or wealth shielding strategies. The discussion about those strategies and the corporate veil (including piercing the corporate veil) is for some other time.
The new diagram
While the image in the first section of this post was accurate conceptually, the number of Rich people who play the game of Credit is far less than the number of Poor people who spend their lives paying interest on their Debt, hence below is a more accurate picture of the distribution.
Credit is a two way sword. It can either kill you or help you. Poor, middle class, as well as the rich – use credit, albeit for different reasons.
Poor use credit because they just do not have the money to pay off their credit card debt.
Middle class uses debt because they cannot otherwise afford to make big purchases like a house or a car. (Upper middle class also uses their credit card regularly to build credit history and get reward points but they pay off their credit card in full every month, and not carry a balance – interest is charged on the carried balance).
The rich use credit because they know how to play the game. For them credit means enhanced returns due to leverage, significant tax benefits, and a means of liability insurance.
Hopefully I have lived up to the promise I made earlier today – by the end of this post, you will now what I mean by “Rich play the game of credit”.