In the past article, we’ve talked about the 5 Principles of Borrowing. Let us re-cap what those principles are before we proceed:
1. Borrow for Something You Need – Not Want
2. Borrow an Amount that is Within Your Repayment Capacity
3. Avoid Borrowing to Finance Depreciating Assets
4. Avoid Being a Guarantor
5. The Borrower has a Moral & Absolute Commitment to Repay
In this article, we’d like to talk about the 3 different types of debt – so that you’d be able to better differentiate them before you “befriend” them.
What’s the difference between “Good Debt” and “Bad Debt”?
Is there such thing as a “Good Debt”? Yes, there is and that’s debt that can provide a financial pay off. Borrowing to buy a home, paying for a child’s education, advancing your own career skills, or starting your own business can provide long-term financial benefits.
Bad debt is when you borrow for things that don’t provide financial benefits or last as long as the loan. This includes borrowing for vacations, clothing, furniture, home-appliances or even dining out.
In the process of sorting through the negatives of debt, it is possible to draw a somewhat hasty conclusion that all debt is bad, and counter-productive. Of course this is not true. There is a productive use of debt by individuals, businesses, and even charities.
To understand, we must define productive and non-productive debt:
· If I borrow money to buy an experience or things that I cannot pay for, and incur debt with high interest charges, I have burdened myself with non-productive debt.
· If I borrow money to acquire an income stream that contributes to repaying the debt incurred, as in buying a shop lot which is being rented out (to a good tenant, hopefully!), I have made a productive use of debt.
· If I borrow money on my margin account to speculate on a “hot” stock based on hearsay/ gossips, I have saddled myself with dangerous and non-productive debt. In essence, I can lose the money (in most cases) and still owe the debt.
· If I borrow money to make a home purchase, and I plan to stay in the home for the foreseeable future, I will probably at least break even, over time through the capital appreciation of my home. In any case, it would have saved me on the rentals had I rented a home instead of buying one, of which, I have made productive use of debt.
· If I borrow money to purchase a new car, and owe more than 90% of its value, I am immediately upside down on the use of debt if the car is stolen. Are you aware that in most cases, a car depreciates about 1/5th in value the moment it leaves the showroom? As your insurer only pays the market value of your car at the time of loss, you’d need to make good the shortfall.
· If I borrow money to start my own business, I could write-off the interest costs against the revenue of my business and thereby saving myself off some taxes. I could even use the amount borrowed to expand my business further and this would be a productive use of debt.
Borrowing can be a productive, wealth enhancing activity, or it can be a “slave to the lender” type of experience. A wise man utilizes debt as a tool to build wealth, obtain favorable tax treatment, and expand the assets under management. A not-so-wise man most frequently thinks of debt as a tool to acquire something he has not had the discipline to save for, nor the patience to wait for.
Not all debt is counter-productive. Sound financial practice requires the benefits produced by the debt to service the debt, and repay the original capital. When we apply these principles to business, the result is the same. The cash flow created by the application from proceeds of the loan must provide an expanded flow of income able to service the credit requirements plus repay the original loan.
What About the third type of Debt?
Despite your best efforts, you may find yourself in severe debt. This is not the kind of debt that you’d want to get yourself in but things just can get out of control. This is when the bad becomes worse and you’re totally consumed by it. Here are some tell-tale signs if you are encountering The Ugly Debt:
· Borrowing to pay off other loans.
· Creditors calling for payment.
· Paying only the minimum on credit cards.
· Maxing out credit cards.
· Borrowing to pay regular bills.
· Being turned down for credit.
· Your friends and relatives start avoiding you.
· And the ultimate - red paint splashed across the walls of your house!
However, all is not lost and you’re not alone. Help is just a phone call away. A credit counselling service can help you set up a plan to work with your creditors and reduce your debts. All that’s required is your total commitment to change to a more prudent lifestyle and be disciplined with the plan.
A Double-Edged Sword
Debt is indeed a double-edged sword. Use it wisely, it can help you leverage on your wealth enhancing activities and provide you with long term financial benefits. Abuse it, it’ll not only cut you but may cause you to bleed to death! Therefore, before you start “swinging” it, make sure you understand the principles behind it and use it responsibly.