Is debt good or bad?

Published: Sunday | December 23, 2012 Comments 0

Oran A. Hall, Contributor

Debt used wisely and moderately can boost your standard of living significantly. On the other hand, debt used carelessly or too much can be a major obstacle to wealth creation, a good retirement, financial health and emotional peace.

The prudent use of credit allows you to improve your standard of living and build your wealth by allowing you to purchase large and productive assets earlier than you would normally have been able to if you were to use cash. By allowing you to spread your spending power over time, it allows you to benefit from the time value of money.

This is so because inflation causes money to lose its value over time: the dollar you pay out tomorrow will buy less than the dollar you pay out today. Spreading out your payments over time also helps you to avoid serious disruptions in your cash flow.

Buying on credit is particularly beneficial during periods of rising inflation when postponing a purchase may cause you to buy at a much higher price.

Here, the Rule of 72, which works for you on your investment, now works against you. Remember the Rule of 72? It's a simplified way of calculating how long it will take, in this case, the cost of an item to double by dividing the annual rate by 72.

To buy later at a higher price requires a larger outlay of funds. But buying on credit later is a two-edged sword, for you may require a larger deposit and may be required to pay higher periodic instalments. It may be better, in this case, to buy on credit now.

But buying on credit has a cost - interest. If the rate is high, it could make the monthly or weekly payments so burdensome you could lose your asset.

Quick elimination

Often, a short repayment term is taken and, while this leads to quick elimination of the debt and a relatively low pay out of interest, payments can be onerous.

Accepting longer payment terms and the resulting lower periodic payments effectively increases the total amount of interest paid over the life of the debt. You should, therefore, be very careful when contemplating if you should incur a debt.

In one sense, good debt is that incurred to meet a need that, otherwise, you would not have been able to pay for without wiping out your cash reserves or liquidating or significantly reducing your investments.

Good debt is also money borrowed and used to make a higher return than the cost of borrowing. It is money borrowed to improve the value of an asset as usually happens when a home equity loan is used to make improvement to your house.

The major problem in such situations is that, although the value of the asset may increase, it may not generate sufficient cash flow, if any, to service the debt.

Good debt, then, is that incurred to acquire such assets as a home, a business, or an automobile for business, and for educational purposes. At the prices at which houses sell, few people would be able to afford one. Borrowing to make the purchase allows you to shelter yourself and your family.

It eliminates the need to pay rent to use somebody else's house and allows you to build up equity in the asset.

Borrowing to purchase a building for commerce and office space also eliminates the need to pay rent, gives you flexibility in how you use the facility, and allows you to own an asset that can appreciate significantly over the long term.

Borrowing funds to invest in a business will give you the opportunity to earn substantially more than you could even earn in the employ of another person. Additionally, it creates opportunities for other persons to earn an income from your business.

Education opens the door to many opportunities in business and the professions. It equips you to increase your earning power.

You will notice that all of the above will give benefits to you in the long term, often extending long past the final payment of the loan.

Bad debt is that which does not generate permanent or long-term benefits to you. It is often used to purchase things which are consumed quickly - such as meals and vacations - so quickly, in fact, that you are still repaying the loan after they have been consumed.

It is often incurred to purchase goods and services you do not need or cannot afford and to buy on impulse. These are instances of overspending.

You take on a bad debt when you use credit to meet routine, basic living expenses, when you take on high-cost debt, and when you acquire depreciating assets, which lose their value with age, such as appliances and furniture.

If you must buy depreciating assets on credit, it is best to minimise the cost to you: buy later rather than now if prices are stable. In the meanwhile, set aside a sum equivalent to the monthly instalment to increase your deposit and lower your periodic payment.

Alternatively, consider taking a loan from your credit union rather than using hire purchase, which is generally very expensive even if the payments seem small.

Here are some general guidelines: Borrow to acquire assets that generate income, that appreciate, or that have a value that is equal to or greater than the sum borrowed; and most of all, borrow a sum that is within your ability to repay.

Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers free counsel and advice on personal financial planning. Send feedback to finviser.jm@gmail.com

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