When You Spend Your Capital on Your Current Expenses

by Manshu on March 16, 2009

in Opinion

In hindsight, it is easy to understand the mistake that most home-owners made when they tapped into their Home Equity to renovate their bathrooms. I think a point that most people don’t address is how the financial markets advanced, without any advancement in the financial literacy of people. To me, this is one of the causes of all this trouble that is not talked about frequently.

Let’s take a look at the whole situation from the start to see where it goes.

Capital Expenses and Current Expenses

You can broadly think of all the money you spend as “current expenses” or “capital expenses”.

Current expenses are the things that you need to buy every month – month after month, in order to maintain a certain standard of living and go through life. So, stuff like groceries, power bill, internet bill, shopping for shoes and clothes form part of current expenses.

Your capital expenses are big ticket expenses like buying a new car, new house, jewelery or even a holiday.

Most people earn a salary and meet their current expenses out of their salaries. So the salary is like a “current income”. After spending a part of their salary on their current expenses, whatever is left, goes to – Savings. This is most people’s – Capital.

This capital is then used for big ticket expenses like houses and cars. The capital will usually not be in cash or a checking account, but will be split into different type of assets.

So a typical salary earner will have his capital split into – stocks, bonds, gold, houses etc.

Now, selling your stocks or tapping into your savings to go to a restaurant or re-decorate your bathroom is a bad practice. This is easily understood by most people and normally people are prudent enough not to do this.

Securitization of assets throws in an angle that entices home-owners to spend their capital on their current expenses.

Basically, the availability of credit on your home or on your stocks mean – that instead of having to sell off your stocks or homes to raise the money – now you can keep your home, and still raise money out of it.

This is where a really big illusion is created and the line between credit and capital is blurred.

Your savings that are invested in your home or stocks is your capital. If you spend your capital on a fancy vacuum cleaner you will be in trouble. But if you take credit and spend it on a vacation in Hawaii – you will go broke.

A house used to be a really illiquid asset and therefore the chances that someone sold off their house to go for a vacation used to be negligible.

However the advancements in the capital and credit markets made it possible to not sell your house, but still take a loan out of it, and this led to the kind of spending bubble that we saw.

Now securitization is just a tool and in itself is an inert thing that is neither good nor bad. The way you use it makes it good or bad. The way most humans are wired – this thing turned out to be disastrous.

There is not enough emphasis on financial literacy in formal education and the best chance any one has got — is to learn good spending habits from their family.

But, if that doesn’t happen – then you are pretty much on your own. When advancements in the capital and credit markets brought forth new tools for people to explore and get “rich” the lack of financial literacy was magnified and the chances that people made financial mistakes were greatly increased.

There is slightly more emphasis on financial literacy today, than it was before, however it is still up to each individual to learn good financial practices and stay out of trouble. The tools are there and the internet has made those tools accessible to a lot of people. The next step to  remain out of trouble is for people to explore those tools and use them for their benefit.

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