The basics of debt: Jim & the bike.

The basics of debt: Jim & the bike.

I love thinking about debt. Sure, I’m a little crazy, but it really is a fascinating subject. Please ignore inflation, it just gets in the way of illustrating the point. So, what is debt? Let me explain it using some fundamental basics as explained by an accountant, and then I’ll go into it a little deeper.

Jim is 15 and needs $500 to buy a bike so he can do a paper route for $20/day, Jim also wants to impress the ladies with his new bike. Jim thinks he can easily pay it back in 6 months after money for PlayStation games. I am able lend Jim $500. However why would I lend $500 today, just so I can get back $500 in 6 months, that does not make sense for me. I want a new TV, I could just buy my TV now, rather than in 6 months. Jim says to me, “Well Doug, I’ll give you $30 extra, $530 total in order to compensate you for waiting for the TV.” This means I have a choice (refer back to post about financial decisions being all about choice), I can either buy a TV now, or wait 6 months and get a TV & a slab.

This concept is known as the time value of money, if you have the choice between getting $500 today, and $500 in 6 months, a rational person would always choose $500 today.

Now let’s make it a little more interesting. I know Jim is a PlayStation addict, he could very well end up playing games until 1am everyday and get fired from his paper route, so I am fearful Jim will not pay me $530 in 6 months, but Jim’s dad has been mowing people’s lawns for 30 years, he needs $500 to fix his mower and he will offer me the same deal, $530 in 6 months. I have leant money to him before, and he always pays it back. Obviously I would choose Jim’s dad, he is risk-free and I’m guaranteed to get my TV & slab in 6 months.

Young Jim though really wants his bike, he knows I think only about money so he says “Doug, I’ll give you $500 + $30 + $30 = $560 total in 6 months” so he is offering me;
$500 Original loan amount
$30 To compensate the time value of money
$30 To compensate me for the additional risk of lending to Jim

Again it all comes down to me knowing what my choices are, I can buy a TV now, or I can buy a TV & a slab in 6 months if I loan to Jim’s dad, or I am pretty sure I can buy a TV a slab and a couple pizzas if I loan to Jim.

Now there is no right or wrong answer, this concept of risk vs reward is present in every investment decision you will ever make. Out of interest the “Risk-free” person in real life is considered the Australian government, they always pays their bills, and if absolute worst came to worse they could just print more money to pay you back.

I think there are many mistakes people make while investing, and this is one of them, people get caught up in the complexity of the whole situation without breaking it down to the very basics for themselves. If you can invest in a business that might give you 6% returns, or you can almost “guarantee” a 5% return by depositing the money in the bank, which is the smarter decision for you?

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