Debt

Debt is like cholesterol, many people think it’s all bad, when in fact there is both good debt and bad debt. Taking out the right loan for the right reasons can be a very important way of growing your wealth, but taking out the wrong loans for the wrong reasons can be very destructive.

The first thing to get a handle on, before you focus on investing, is unhealthy debt and that means understanding how to distinguish it from healthy debt.

Good vs bad debt

There are two things to consider when evaluating your debts:

1. The debt itself, including how much you have borrowed, how much interest you are being charged, and how long you have to pay it back (the term), and
2. What you are using the borrowed money for.

Evaluating the debt itself is reasonably simple. High interest rates are bad, low interest rates are good as a general rule. The Prime Lending Rate is a good benchmark to use to evaluate the interest rate of a loan. If you are offered a loan at below or close to the Prime Lending Rate then you’re getting a good rate. If not then you should be aiming to pay off the loan as soon as possible.

Loans that have long payback periods are also generally better than short-term loans. For long-term loans your minimum payments are spread out over a long time so each individual payment will be lower, demanding less of your cash each month to pay them back. But, the longer you take to pay back the loan the more you’ll end up paying as interest instead of as repayments of the loan itself (called the principal).

The best way to evaluate whether or not a loan is good or bad for your financial health (assuming it’s got a reasonable interest rate and term) is against what you use the money for. Healthy debts are only used to finance investments into something that appreciates in value (and that could be yourself).

If you borrow money to buy a house there is a good chance that if you sell the house one day you’ll get more money than you paid for it, i.e. the house (an asset) is likely to appreciate in value over time.

Likewise, if you borrow money to get a new qualification or skill that will increase your earning potential you can think of that as an investment in yourself.

Those are both good reasons to take out a loan as long as the interest on the loan is not too high and you can comfortably afford the minimum amount payable each month.

In contrast, using debt to pay for things that you consume or that lose value is generally a bad idea unless you are able to repay the loan before you pay any interest (e.g. if you pay off your credit card in full each month you can benefit from the rewards you earn and improving your credit score but avoid the high interest rates).

Don’t take out loans to pay for appliances, clothes, holidays, or anything else that you could live without. Rather save up for them in an interest bearing account and pay for them when you can afford them.

We are all bombarded with messaging and advertising encouraging us to consume more and the best way to stay financially healthy is to resist the temptation and only consume what you can afford.

Be very wary of any offer to buy now and pay later, you will almost certainly end up paying more in the end.

Pay off unhealthy debt first

Money you have set aside for saving and investing should go to paying off unhealthy debts first.

It's very unlikely that you are getting a better return on any investment than the interest you are paying on unhealthy debt. If you're in a debt trap, focus on climbing out of that first. If you don't then you risk being forced to sell off your investments later to finally break out.

Credit Scores

One thing to consider when taking out debt is your credit score.

Your credit score is a number that is calculated by credit rating agencies based on your financial behaviour. Banks and other service providers report transaction data to the credit rating agencies who calculate your score and share this companies that run a credit check on you.

Even missing a bill payment can negatively affect your credit score. as service providers also use the credit agencies to decide who to give contracts to with payment terms. For example, if you have a cellphone contract then you are getting airtime and data on credit. You only pay for it at the end of the month. As a result, before you get a cellphone contract the provider will usually run a credit check on you.

Credit scores and debt are a catch-22 for responsible young people. You can only build up your score by using credit but as we've discussed this is generally not a healthy. To improve your credit score without the risk of accumulating unhealthy debt, use a credit card for your day-to-day spending but make sure you always pay it off in full each month.

Should I use a loan to buy a car?

This is a topic that generates a great deal of debate. In general the interest rate offered for car finance is quite good but new cars lose value as soon as they leave the showroom floor (i.e. they are not an appreciating asset).

However, new cars are also covered by service plans and warranties making their running costs and the risk of large unexpected expenses lower. 

The amount of value a new car loses also depends a lot on the type of car. Boring practical cars generally hold their value more than exotic or luxury cars.

It generally makes more financial sense to buy a second hand car that’s only a few years old and has very low mileage. But, if you want to buy a new car then it’s worth evaluating how the car you’re looking at loses value. 

Try to find some examples of the car you’re looking to buy in the second hand market and evaluate how much value they lose in the first few years. If the car you want to buy loses value fast in the first few years, you could be in a situation, after a year or two, where you owe more than the car is actually worth.

Borrowing money to buy a luxury car or anything exotic is not a great financial decision.

If you’re a motor-head and desperate to own that brand new sports car, save up for a year or two and put down a big initial deposit so you can significantly reduce the interest payments you make when financing the rest.

Beware of balloon payments

If your vehicle financing includes a large payment at the end of the loan term then you are only really getting a loan for part of the value of the car.

It’s likely that the car won’t be worth much more than what you owe as a balloon payment when that becomes due so even selling the car at that time might not be enough to cover that payment.

In effect, you just rented the car for a few years but still carried all the risk (who pays for theft, damage, breakdowns?) as well as the cost of insurance, fuel, and maintenance. If you look at it that way, do you still want to pay the high cost of “renting” that luxury car?