Debts

Debts are all Bad!?

Posted on May 12, 2008. Filed under: Debts |

 
I was always very skeptical about debt and preferred to remain debt free. Until one day a friend of mine told me that he LOVES debt if it is a ‘good’ debt. His statement became a wake up call for me.

He is right! Debt is not always a bad thing. In fact, there are instances where the leveraging power of a loan actually helps put us in a better overall financial position

The problem is it’s far too easy to spend more than we can afford, especially when we pay by credit card. And the risk would be we let debt get out of hand. On the other hand, avoiding debt at any cost is not smart either if it means depleting our cash reserves for emergencies. The challenge is learning how to judge which debt makes sense and which does not and then wisely managing the money we do borrow.

Generally, good debt is debt that might be considered an investment. Well, it might sound absurd that anything as ‘evil’ as debt be considered an investment! But if we look on the debt to purchase something that will increase in value, or generate return higher than the interest payable and hence contribute to our overall financial health, then it’s very possible that debt is a good one.

For example, a home purchase can be considered to be a good debt. Since homes usually appreciate in value, the mortgage loan you take out to pay for the home is an investment.

Another example of good debt would be debt which produces cash flow. For example, the purchase of a tenanted property as investment. If the rental income covers the costs of interest, it means someone else is paying our house installment for us and also putting some cash in our pocket.

Bad debt includes debt we’ve taken on for things we don’t need and can’t afford (a fancy overseas trip, an expensive BMW, for instance) or goods that are disposable or that depreciate in value. To me, credit card debt is still the worst form of debt one can engage in since it usually carries the highest interest rates. For eg, new clothes are worth little in value, if being not worthless from an investment point of view, the moment we walk out the shopping mall with them. If we buy these clothes on a credit card, and don’t pay off the balance on time, we’re losing money. Interest is added on the unpaid debt, therefore increasing the amount that we owe, the value of our purchase decreases. That’s bad debt.

Another bad debt would be purchasing of a car. Most people go into debt to buy their cars. In fact, for many of us, that is the first big loan we take. That is possibility that we see the car we drive as a status symbol (thanks to the power of advertisement), and often try to finance much more than we can afford.  And of course, everybody knows that cars, like clothes, lose value immediately once it is brought on the road (20% perhaps?). Car loans used to be three or four years. Now in order to make the payments more affordable and encourage people to buy more car than they can afford, loans are extended to as long as 9 years!! By the time we’ve made all the payments, our car has lost most of its value. Of course, a hefty down payment helps, but it also means depleting our cash reserves. 

Generally, to be classified as good debt, the following two elements need to be fulfilled:-

1. Whatever is being financed should last longer than the loan. Hence, since a house lasts longer than the mortgage, paying off our house as quickly as possible may not be the best use of our money

2. Financing should provide positive leverage. The positive cash flow generated from the rented property is one of the example

Whenever we can invest money at a higher rate of return than it costs to borrow it, it is to our advantage. Plus, with a fixed-rate mortgage offered in the market now, we are protected against future inflation. If inflation increases, our rate remains fixed; if interest rates drop, we can also refinance or re-negotiate with the bank for a better rate. And of course we can pay off our mortgage anytime we want to.

I did mention that loan for cars are mainly bad debt. However a car loan (more…)

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