Debt. Is it the devil in disguise or a useful tool to help us increase our standard of living?
It can be both, depending greatly on your knowledge and understanding and how to manage it.
The Global Financial Crisis can attribute much cause to the ‘out of control’ nature and panic due to debt. “Debt” as most of us know it, is receiving money up front and used for the purchase of goods and services which will be paid back at some point in the future, generally with interest.
Debt can be classified into different categories, typically “good debt and bad debt”. This helps us understand the purpose of debt and how much debt we can handle. Bad debt is where there is no return (on the purchase made) from money borrowed, it is not tax deductible or is any debt we cannot afford to repay.
This type of debt usually includes credit cards, personal loans for items such as cars, televisions and general living expenses and in technical terms your home (principal place of residence as the debt is not tax deductible, however many people would argue this is not bad debt).
Good debt is one where the asset purchased from the borrowed money generates wealth and has tax deductibility. These ‘income producing assets’ such as real estate, shares or your business may sit in this category. You might ask yourself why put ourselves into debt at all, but there is a very real need for debt as a sound way to accumulate assets, if managed correctly. Debt can be a very powerful tool allowing us to be able to purchase goods which we cannot afford to pay for outright such as a business or commercial building, but we may be able to easily service the principle and interest associated with the borrowed money.
Good debt management is the key to keeping the stress of borrowing under control. All loans and borrowing involve some form of risk and some stress can be a good thing eg: motivation to act sooner rather than later if things are not going as planned. Good management of debt involves a plan. Why do you want debt? How much debt can you manage and for how long?
Most ‘bad debt’ is accumulated on your credit card, personal loans or store cards which incur high interest charges, fees and get completely out of control very quickly. Bad debt needs to be eliminated (paid off ) as quickly as possible. A great tip is to choose credit facilities with low interest rates and has a long interest free period as possible with low or no ongoing fees. Forget about the gimmicks and perks associated with credit cards, they are only designed to ultimately get you to pay interest on a higher amount of money for a longer period. Paying off the minimum amount each month will never see you paying off your credit card debt so it is good practice to pay off a little more than you owe prior to interest free period ending. If you cannot repay your debt prior to the interest free period in full, than you may have more debt than you can manage. The same can be said for personal loans, they should also be paid off as quickly as possible and always pay more than is required if you can.
Good debt and bad debt can be blurred in their definition and purpose, however education and clarification around what kind of debt you have will go a long way in allowing you to manage and utilise ‘good debt’ where possible. Rules of thumb in relation to lending include;
• Minimise ‘bad debt’ and embrace ‘good debt’ where you can
• Do not create more debt than you can honestly afford
• Do not restrict your cash flow so tight you have no room for emergency funds
• Don’t be afraid of debt but respect, understand and constantly manage it
Yours in prosperity,
The EQUIS Team