When you earn money, you can either spend it or invest it. Even when you don’t have enough money, you can borrow and spend.
But how are earning, saving, investing, loans, credit and debt related? Let’s find out.
In this article, we are trying to learn about the relationship between the many terms that we keep hearing regarding money and finance – investing, spending, buying something on credit or borrowing to buy something, taking a loan, etc.
So, let’s start with the most fundamental thing: Earning money!
Income or Earning Money
This is a very simple, basic thing – you have to earn in order to be able to spend!
You can earn money through a recurring source of income (monthly salary, or profits from business), or through more irregular sources, like bonuses, capital gains (by selling shares or a house), etc.
Let’s say you earn Rs. 20,000 per month.
Out of this, say Rs. 5,000 goes towards rent, and Rs. 10,000 goes towards essentials like grocery, clothes, etc. This is your non-discretionary expense – these are essential expenses, and you do not have an option to not spend these amounts.
Since you spend this money as soon as you earn it, let’s call it your current consumption.
Now, you are left with Rs. 5,000 per month. This is, in a way, extra – something that is left after meeting all compulsory costs.
You have an option to spend it as well: You can buy something for your house, spend it on a vacation, or give a gift to your spouse!
The avenues are countless. And if you do that, again, you would be consuming this money as soon as you earn it. Thus, this would also be your current consumption.
Another option for you is to save this money and invest it.
This means that instead of using the money now, you expect to grow it and use it for future consumption. You are postponing your consumption.
You are sacrificing the current consumption with the expectation of growing the money and be able to use it better in the future.
You can invest the money in a bank fixed deposit (FD), bonds, post office schemes, stock markets, anywhere – the objective remains the same: to grow the money so that in the future, you can achieve more from it compared to what you can get from it now.
In our example, Rs. 5,000 invested today can grow into Rs. 15,000 in 5 years (say, if you invest in equities) – and then, you can use it to buy something much better than what you can buy for Rs. 5,000 today.
So, this is saving or investing: You sacrifice current consumption in order to get a better outcome from the money in the future. In a way, you pay for your future spending from your current income.
Drawing from the future
Debt / credit / loan are direct opposites of future consumption. When you take a loan, you spend the money right now, knowing that you would pay for it from your future income.
Let’s revisit our example. You want to buy a motorcycle. You only have Rs. 5,000, and the bike you want to purchase costs Rs. 45,000. You can wait for 9 months to save up this amount, or you can buy the bike today by taking a loan.
That way, you would get Rs. 45,000 today, and you would be able to buy the bike right away. And, you can pay Rs. 5,000 towards it (as EMI) for 10 or 11 months.
Since you know you would be earning a steady income in the future, you can draw form the future income to buy things today. Thus, when you buy things on credit or through a loan, you pay for your current spending from your future income.
You get to spend the money that you have not even earned – but there is a price you have to pay. The banks or financial institutions that lend you money or give you credit charge extra money from you in the form of interest.
It’s a price you pay for drawing from your future income.
What is the optimal way?
It is traditional Indian belief that you should not live beyond your means. (Sayings like “Jitni chadar ho, utne hi pair pasarne chahiye” testify this!)
I tend to agree with it – you shouldn’t buy something on loan unless absolutely necessary, or unless it is an appreciating asset like a house.
(Read more about the benefits of buying a house in “Settle early in life – buy a home when young”)
So, the choice remains between current consumption and investing for future consumption.
You work very hard to earn money, and you should enjoy it as well. Thus, some current consumption is definitely appropriate.
But at the same time, through investments, you can grow your money to buy even better things in the future. Thus, you should keep aside some of your disposable income for regular saving and investments.
Other articles you might be interested in:
- ICICI Bank hikes interest rates on home loans
- Why you should not stop your SIP when market corrects
- An Introduction to Fundamental Analysis
- An introduction to Post Office Monthly Income Scheme (PO MIS)
- Why you should have a contingency / emergency fund
- Auto Sweep Facility: Smart way to make your money work harder
- Equity Investment is Risk Free – Here’s the Proof
- Income Tax (IT) treatment of House Rent Allowance (HRA)
- Only paid out arrears to be subject to TDS for government employees
- An introduction to Technical Analysis
- Retirement money: How to invest, where to invest
- Do you have an SIP? Don’t stop it!