This week I debated with myself about whether to cover “assets” or “debts”. I finally settled on debt. I think this forms part of the basics that needs to be addressed before moving on to the elements that determine our net worth.
So let’s talk debt. What is debt? Debt, as Wikipedia puts it, is an obligation that requires the borrower (debtor) to repay an agreed amount of money to someone else, the lender (creditor).
The most common form of debt we use in our day-to-day lives is loans. Loans come in the form of bank overdrafts, student loans, car loans, mortgages and credit cards. A loan would usually require repayment in instalments over an agreed period of time and would often come with a premium (in the form of an interest rate) attached to it. The effect of the premium is that the total amount repaid would be more than the original amount borrowed.
We all have those times when we need a helping hand to achieve/obtain that one thing or objective we are striving for. From a best practice standpoint, my advice would be to delay obtaining whatever it is till you’ve saved for it or your investment yields returns which you can use to obtain it. From a more realistic perspective, especially for people who are still undecided about getting financially disciplined and building wealth, then I’d say aim to borrow at as low a rate as possible and make sure agreed repayment schedule is adhered to. I however strongly encourage that everyone gets financially disciplined and begin the work of building wealth to enable financial freedom.
One key question though, why debt? What is it we are purchasing that can’t wait till we have sufficient funds to purchase it with our own funds? The answer to this question determines whether it is a good debt or bad debt.
Yes, Good v Bad debt – a concept I first came across when I read Robert Kiyosaki’s Rich Dad’s Cashflow Quadrant and have since seen it bandied about in several of my networks. Good debts serve to increase one’s wealth e.g. a mortgage on a rental property would which yields income and is likely to grow in value in the long term, is a good debt, while a bad debt serves to increase your liability and are often loans taken to obtain things of depreciating value e.g. a new car, that bling watch that makes you think you are fashionable (speaking more to the young impressionable guys), designer shoe and bag (for us African ladies particularly) or designer clothes. 😊 So take heed, if you are not taking out debt that would contribute to growing your wealth, then it is best to steer clear (or at least delay the purchase till you have the funds to buy it). Below are a couple of pictures that compare and give e examples of good and bad debt.
This post would be incomplete if I don’t touch on credit card debt. In my opinion, while making purchases on a credit cards might have some benefits, I consider it the worst debt one can get into. The benefits of having a credit card are that you are able to instantly make a purchase (even if you can’t afford it), if used responsibly it could help build/improve your credit history/record and more importantly, it is a great way to avoid losses from fraud, as the risk sits with the credit card company. The flip side of using the card to purchase things you can’t afford however, is that you get into the worst type of debt possible!
I say it is the worst debt possible because you get caught in a cycle by not paying off your credit card bill in its entirety (which is the only way you are able to enjoy the benefits that come from using a credit card, unless of course you have a 0% interest credit card). No matter how small the interest rate (if it is not 0%), not paying your bill in its entirety within the deadline indicated, will lead you into the trap of servicing a never ending debt, especially if you are only paying the minimum amount payable. This is the lender’s preference as that’s how they make their money; they keep you chained to them, paying interest!
The below table is my attempt to put it all into context. It shows a loan of £1,000 on a credit card with 20% APR[1] – all figures are made up. As depicted in the spreadsheet, by paying the minimum amount permissible, total repayments made after one year would be £285.98, but interest of £185.88 has also been accrued on the balance. Note how the debt is in effect being compounded and is growing exponentially. At the end of year one, in spite of the £285.98 repayments made, outstanding balance remains £899.91 (not £714.02 – being the deduction of your repayments from original £1,000).
I went a step further and used Barclaycard’s repayment calculator to generate the pie chart shown above; note how interest paid overall is more than the initial loan on the card balance; and more importantly note how long it takes to pay off a £1,000 – more than 18 years!
The key message I want to get across with this post, is that if you have to use debt, make sure it is good and not bad debt. Credit cards, in spite of its benefits, are “NO, NO” in my opinion, unless you are using it to build your credit record or to protect yourself against fraudulent purchases, but if you choose to use it for those reasons, you’ve got to disciplined enough to pay the bill off in its entirety and within the deadline indicated on the bill.
Enough from me about debt (or should I say credit cards, as it seems to have been the focus of the post).
Final words for today, PAY DOWN/OFF YOUR DEBTS.
Once this is done, you are ready to begin the journey to financial freedom.
Like, share and let me know in the comments, if these posts are useful and what else you’d like to see me write about.
📝 Originally shared under my first blog, bitalks; part of the journey that shaped Life’s Riches.
[1] Annual percentage rate