With President Obama signing the credit card reform bill into law, the pile of credit card debt sitting on your balance sheet might not seem so bad and could possibly be getting better. But is that true?
To find out, we first have to understand what debt really is – leverage. Yes, debt is leverage, nothing more, nothing less. It simply magnifies the gains or losses on assets purchased with the borrowed money.
Let's use housing as an example. If you buy a $500,000 house with 20% down payment ($100,000), you have to borrow $400,000. You are using four parts borrowed money and one part your own money, resulting in four-to-one leverage. If the price of the house goes up 10% to $550,000, the gain to you is $50,000, which is 50% of your initial investment. In other words, on a 10% increase in the price of the house, you made a 50% profit.
What this means is whoever loaned you the money isn't going to gain if the house goes up in value. All you have to do is pay them back the amount promised. You get any gains all to yourself. However, this works in reverse as well. The lender doesn't share in the gain, but they don't take the losses either (unless there's a foreclosure – a subject for another time).
If the house goes down 10% to $450,000, the loss to you is $50,000, which is also 50% of your initial investment and a 50% loss to you. Just as before, the debt when the value changes acts as leverage to magnify your position, in this case for big loss. (To learn more about real estate in a recession, check out Buying A House In A Down Market)
It's easy to see how people got into trouble in the housing marketing collapse with zero down loans. Any fall in price put them underwater in a big way since they absorbed 100% of it. With no cushion from a down payment and increasing interest rates from adjustable loans, it's no wonder there's so many foreclosures.
But housing historically trends upward and homes are typically appreciating assets, which is why leverage in buying a home is so often effective.
Credit cards, on the other hand, are used to buy depreciating assets, things that fall in value or just get thrown away once used. So using debt to make these purchases leverages their cost, sometimes considerably. This is why credit cards, even if interest rates were reasonable, would still be a bad idea. In general, borrow only for appreciating assets and avoid borrowing for depreciating assets. Your balance sheet will be glad you did.
So despite the legislation, which will help consumers a bit and we all should be thankful for that, the answer is that credit card debt will continue to stink. Unfortunately, all that credit card debt sitting on you balance sheet is still just a big pile.
Learn more about managing that pile of debt by reading our Expert Tips For Cutting Credit Card Debt.