An attendee in our seminar asked, “can we actually say that some debts are good while others are bad”? The answer to this question is not straight forward. A debt that looks really bad to the common eye can actually be a game changer in the business of someone else. Read on to find out why!
A good debt places cash into your pocket while a bad debt takes cash out of your pocket.
There are three parameters that can be scrutinized to determine the good or badness of a debt. These include interest rates, the purpose of the loan and the owner of net cash flows.
Exploitative interest rates will make the debt you are getting bad because it will take money out of your pocket, for example…
When you borrow from a shylock or mobile lender at interest rates of 20% per month, you are shooting yourself in the foot. There are literally no business ventures that can give you that kind of return, hence this means you will have to dig deeper into your pockets to repay the loan.
Purpose of the Loan
What do you want to do with the loan?
In financial terms, we broadly spend our money on two broad categories of consumables, referred to as needs and wants.
Needs refer to those things that we must consume in order to stay alive. These include food, water, medication, clothing, and shelter. If we miss partaking of any of these; then our survival is seriously compromised and we can actually die.
On the other hand, wants are those things that make your life comfortable, such as a private car, expensive clothing, electronics, etc.
The way you finance needs should be very different from the way you finance wants. Broadly, needs should be financed in whatever way, including borrowing while wants should be financed via savings.
If you take a loan to finance a want, most probably a depreciating asset like a car, then this is a bad debt because it will take money out of your pocket into someone else’s without any promise of returning the money to you later.
If you take a debt to finance a business, this is good debt because it promises to put the net cash flows into your pocket. Good debts include small business finance loans or investment in appreciating assets such as real estate.
Ownership of net cash flows?
Financial transactions, especially borrowing have a net gainer and a net loser. You are a net gainer if the resultant cash flow comes to you, while you are a net loser if you are the one to ultimately part with the money.
It is difficult to judge in advance who will be the net loser because we purchase things for very many different reasons including boosting our own self-esteem that cannot be quantified. However, put simply, as long as you are the one who will write the ultimate cheque to the other person, then you are the net loser.
Before deciding to purchase anything using debt, ask yourself, will I be the net gainer financially? If you will be the net loser, then save and buy whatever it is you want to buy.
It is common knowledge that “it takes money to make money.” As a business person, you know that you must supply a service or good for you to be paid. However, to create this good or service requires money and if you don’t have the money upfront, then you must borrow. Therefore, the debt that helps you to generate income and increase your net worth is good debt.
Some Examples of good debts are discussed below!
Technical or college education.
There are two types of education, Technical or practical training and there is academic training. Technical training equips an individual with the skills useful to do a certain job or produce a particular service or product, e.g. nursing, accounting or carpentry. Academic training, on the other hand, is intended to increase mental faculties in general and is mostly used to help in thinking.
Both types of education will increase your earning potential and have a positive correlation with the ability to find employment. The higher your education, the easier it is finding new opportunities should the need arise.
An investment in a technical or college degree is likely to pay for itself within just a few years of the newly educated worker entering the workforce. To maximize the value of taking on debt for an education, degree or technical programs must be chosen carefully.
If there’s no career path or little income to be earned from the degree you pursue, your student loans can quickly turn into bad debt. Many a time we see individuals enroll for masters simply because their friends enrolled and since the courses taken are not needed at their workplace, they remain in their current jobs frustrated with their certificates.
Small business ownership.
Every private business that is successful today started as a small business. Entrepreneurship is the art of identifying a need in society and fulfilling it to make money. In the process, you end up being your own boss.
Starting a small business helps you avoid reliance on third parties for your livelihood while increasing your potential earnings by your willingness to put in a little more effort. You can turn your drive and ambition into a self-sustaining business and down the line, an initial public offering (IPO) that can result in major wealth. Think about the facebooks and Ubers of this world. Like education, this too comes with risks. Many small businesses fail, but your chances for success are greater if you choose to work in a field you are passionate and knowledgeable about.
Real estate, including homeownership.
On the residential front, the simplest strategy to make money involves buying a house and living in it for a few decades before selling it at a profit. Residential real estate also can be used to generate income by taking in visitors through Airbnb or renting out the entire residence.
Commercial real estate also can be an excellent source of cash flow and capital gains for investors.
For consumers who are already in debt, consolidating higher-interest debt by taking out a loan at a lower rate of interest can be beneficial. The key is to use the cash that has been freed up from lower payments to keep paying down the debt.
In Kenya, many employed people use this method to pay off their car loans by remortgaging their houses because house repayments are usually lower because of the longer tenures.
Borrowing to invest.
Leveraging refers to borrowing money at a low-interest rate and investing it at a higher rate of return. Unfortunately, it comes with numerous risks for rooky investors as well as the potential hazard of losing a significant amount of money.
This is an option that should be pursued only by knowledgeable established investors who can afford to absorb losses in the event an investment goes south.
A debt is considered bad if you are borrowing money to purchase depreciating assets. In other words, if it won’t go up in value or generate income, you shouldn’t go into debt to buy it.
Some particularly notable items related to bad debt include:
You think that you need a new car. In fact, some of your friends and colleagues already own one. Yet, a new car can cost an arm and a leg. While you may need a vehicle to get yourself to work and to run the errands that make up everyday life, paying interest on a car purchase is simply a waste of money. By the time you leave the car yard, the vehicle is already 20% less than it was when you paid for it.
If you must buy a car, put your ego aside and pay cash for a used car. If you can’t, take out a loan to buy the least expensive reliable vehicle you can find and pay it off as quickly as you can.
If you must live beyond your means by driving the latest new car in town, look for a loan with little to no interest. While you’ll still be spending a large amount of money for something that eventually depreciates until it is worthless, at least you won’t be paying interest on it.
Consumption loans (Clothes, consumables, and other goods and services).
Your high school classmate wedding is coming up and you are on the bridal party. You need a new dress, that you are sure you will only wear once. Why not hire it?
Vacations, fast food, groceries, and gasoline are all items commonly bought with borrowed money. Every penny spent in interest on these items is money that could have been used more wisely elsewhere.
Mobile loans, Shylock loans, and Credit cards.
Mobile and Shylock loans are quick money to help you plug immediate shortfalls in your budget, but just remember the interest is exploitative. These should be considered in extreme situations of life and death.
Credit card interest rates charged are often significantly higher than the rates on consumer loans, and the payment schedules are arranged to maximize costs for the consumer. I remember a credit card I once owned whose repayment was the 15 th of each month when my salary came into the account on 25 th. Each time a repayment was due, there was no money on the account and the Bank made it so hard for me to change the date, so I kept paying late payment charges until I decided to cut up the card.
There are some great credit card reward programs available for consumers. The money spent using credit cards can help buyers earn free airline tickets, free cruises, cash back, and a host of other benefits. If you have the discipline to pay off your balance every month, this is worthwhile. Otherwise, the interest spent on the credit card debt offsets the value of the rewards.
Determining whether or not a debt is good or bad sometimes depends on an individual’s financial situation, as well as other factors. It is important to always remember that good debt places money in your pocket while a bad debt takes money out of your pocket.