Growing up, I believed that all debts were wrong. Just utterly wrong (this was my father’s influence). I have always thought that if one owes someone money, that someone may be behind eight ball (that was way too judgmental!). For this reason, I always paid cash on my purchases whether big or small and I refused to acquire a credit card until one time, after flying from Wellington to Christchurch and I needed to rent a car, the car rental company gently declined to lease me one even when presented with my debit card. They wanted a credit card which shortly after their brief explanation, it made sense to me. However, in saying that, I use my credit in the strictest way I could possibly and reasonably can.
It is a fact of life that one way or another, we may need to obtain a loan or to buy on credit. However, it pays to be informed of what we are getting into especially the risks and benefits associated with it. It is necessary to have nuanced analysis and understanding of indebtedness.
Let’s make this simple. A good debt is a debt that boosts your net worth and improves your financial future. There is a clear purpose of taking out a good debt and a carefully laid out plan of paying it back.
So what are examples of good debts?
MORTGAGE. Well, everyone needs somewhere to live, right? Most people buy a house not only to have a roof under their heads but also with the hope that its value will increase over time, which usually is the case (unless you buy a home in the middle of a desert!). Besides, rent is outrageous in some areas in the country. Compared to other types of loans, mortgage has a low interest rate which qualifies it as a good debt. It also builds up equity which you can use to buy another property to start your investment portfolio, thus create wealth; or fund your children’s education.
EDUCATION. Student loan helps students increase their future value. Generally, it is easier for someone who finished a university study to enter into a higher paying workforce than someone who does not have a degree. In simple term, it increases your earning potential. It may be a big debt which takes a long time to pay, but student loan (at least owed from the government like in NZ and Australia) is interest-free! And you are only to commence your repayment once you have jumped into the work fence.
BUSINESS LOAN. People have different opinions about taking out a loan to start or expand a business. Because a lot of businesses fail from its natal stage, you can also meet a handful of naysayers along the way. More often than not, those who are successful can back you up in your plan to draw out a loan for your business. The important thing to consider here is whether you are planning to start or expand your business, you must have a sensible and prudent business plan and has done your due to diligence that will help you become successful in the arena.
Now, let’s look into this. Bad debts are money owed to purchase things that quickly depreciate in value like cars, clothes, appliances etc. Bad debts commonly have high interest rates.
CAR FINANCE. While it can be as high as a kite to be able to acquire a brand new car, it may not be the best idea, especially if you are taking a loan, for the sole reason that its value depreciates significantly the instant you drive it off the lot and continues to diminish over time. If you really need a car, let’s say the public transport in your area is quite disappointing, opt for a cheaper second-hand one. Cam McLellan’s advise was glued to my brain when I read his book, My Four Year Old , The Property Investor. He said “when buying a car (while building your fortune), drive the cheapest car your ego can handle.”
PERSONAL LOAN. Generally, people draw out a personal loan to consolidate credit card debts and other arrears that seem to keep them treading water. While personal loan can be used for many purposes, it is considered a bad debt by virtue of its soaring interest rate which can be as high as 22%. The latter may be higher if you have a not-so-good credit history or if you are opting for unsecured loan.
CREDIT CARD DEBTS. One of the most expensive way to borrow money is through the use of credit card. Credit card debt has become one of the major causes of stress in our increasingly consumerist society. Some people tend to be oblivious to the fact that once a credit card is swiped, debt is already incurred. Like a personal loan, credit card can be helpful in many ways. However, if you don’t hold yourself in check with your repayment, then an unnecessary high interest rate will farther the balance due. In many cases, the inability of some credit card users to chase their mounting debts results to its interests hitting the ceiling which are way higher than what are actually owed, thus befalling to a more financial pressure.
THE DOWNRIGHT AWFUL DEBT
Hey guys, this is the ugly one, the worst kind, the most unfavorable!
CASH ADVANCE. Otherwise known as a payday loan, cash advance is short-term cash loan in which a borrower writes a personal check held by the lender with a specific fee plus a colossal interest. The borrower pays the lender on the next pay day or an agreed time for full repayment. If this is not met, the debt will rollover with even higher interest plus fee. The lenders are often described as loan sharks because they usually charge up to 300% interest or to some extent 500% over a certain period of time. You must do your best not to fall into this trap!
PLUS… THE GOOD THAT MAY TURN UGLY
BORROWING FROM FAMILY AND FRIENDS may be one of the easiest way to loan money but it can turn out nasty and can ruin relationships. Some borrowers turn to their kins and pals asking them for help to get through the line while equipped with beautiful promises of paying the loan at a specific time. Yet here and there, that specific time is usually extended, worse forgotten (usually by the borrower). At times, the lender is reluctant to remind the borrower to make repayments because it is just agonizing to do so repeatedly especially if the latter is unwilling to meet his/her obligation. That is when heartbreaks start to cut through bonds that sometimes ensues to prolonged squabbles.
The truth is most people cannot pay cash with all their purchases in which case, incurring debt is inevitable. In light of this, we should endeavor to be responsible, controlled and disciplined as much as we can to ascertain that repayments are made on time. If not, even good debts can potentially become bad. Richard Meadows eloquently stated “Think of debt like a power tool. It’s incredibly useful in the hands of a skilled operator, allowing you to cut through all sorts of obstacles. However, you better know what you are doing. “