Friday, Aug 18 2023
Source/Contribution by : NJ Publications
The one thing that keeps most people awake at night is not a lumpy mattress or bad dreams. It’s the Big Debt!
Living a debt-free lifestyle is often the dream for many of us, but it’s not always feasible. Debt has become an integral part of our lives . Very few people earn enough money to pay cash for life's most important purchases: a home, a car or a college education. None of us like paying interest but the problem is we don’t save enough cash for these huge purchases. So, what option do we have? Practically, borrowing money is the only solution. So, it is likely that you will have to take on debt at some point in your life. Being in debt is not as bad as it’s painted to be. It’s important to know that not all debt created is equal. The right sort of debt can have a positive impact on your financial well-being. It can be a wealth-building tool when managed properly but also could have serious financial consequences if used irresponsibly.
Most experts categorise debt into two separate categories: good debt and bad debt. Here’s a breakdown of a few different types of debt and certain loans that fall into this category.
The Good Debt
Good debt is defined as a debt that has the potential for increasing your net worth or income over time. While you’ll still have a regular payment to factor into your budget, “good debt” pays off in the end. It’s an investment that increases in value over time. These debts pay for tools that will help you create a brighter financial future. Good debt may also be in the nature of consumption that seeks to alleviate your status to positively impact your business or practice. However, good debt isn’t without risk if you overdo it. As a general rule, you should not borrow more than what you can handle. Some of the popular examples of good debt are:
a. Business Loan:
Starting your own business is another investment for your future. The money that you borrow to start your own business can be considered good debt. A business loan can allow you to start or grow a profitable company to increase your future cash flow as long as you have a sensible and realistic business plan. If your business does well it will end up being worth far more than the loan you originally took out. However, one has to make sure that your personal wealth and business are kept distinct and not risked out too much with business loans as a business failure or a bad economic cycle may ruin everything for you.
b. Home Loans:
Home loans are also generally viewed as a source of good debt. The money you pay towards the home loan can be seen as an investment. When you buy a home, you can stay in it for decades and later when there is price appreciation, you can sell it at a profit. Residential homes can also be rented and it can also be a good source of income. A house can be a source of social respect and great emotional comfort, especially when debt free. Further, there are tax benefits available on interest and capital repayments. However, the quantum of loan you take should always be a factor of your income where EMI payments are not a burden.
c. Student Loan:
Student loans allow you to get an education and increase your long-term earning potential. Education has a direct impact on your future career prospects and earnings potential. Well-educated workers are more likely to be employed in good-paying jobs and tend to have an easier time finding new ones as and when the need arises. An investment in a college or technical degree can often pay for itself within a few years of entering the workforce. However, not all degrees are of equal value, so it’s worth considering both the short-term and long-term prospects for any field of study that appeals to you.
The Risks of Good Debt
Too much of any good thing is harmful. And that is indeed the case with debt. When we take good debt, we are making assumptions about the future based on our own goals and typical results in the past. But, there are no guarantees. Taking on more loans than you can afford can make it difficult to save for the future and add to the stress of repayment of loans. Before taking on any debt, it is always smart to carefully consider what return/benefits you expect to get and what could go wrong.
The Bad Debt
Bad debt involves borrowing money to purchase rapidly depreciating assets or solely for unjustified consumption. After months or years of making payments, you may not have left anything of value. These debts often come with high interest rates, costing you more out of pocket and some debt can lead to greater financial obstacles down the line. However, not all consumption expenditure is bad as one, after working hard, would want a life of comfort and lifestyle justifiable as per income and even aspire for greater dreams. The real question is affordability. If one can afford to make the full expenditure without a dent in savings and still takes a loan to delay payments and take advantage of the credit, such a loan may not necessarily be a bad debt. What makes it bad is going overboard and spending before you earn or taking a loan on the basis of your potential future earnings. Here are a couple of usual examples of bad debt.
a. Auto Loans:
An automobile is a necessity today for many. But for most of us, the cars we end up liking are always beyond our budget and we are tempted to take loans for that extra upgrade. By the time we drive the brand new car from the showroom to home, the vehicle already is worth much less than the amount we bought it for. The depreciation of the car is high and with high-interest payments, a big loan will soon start hurting in your pockets. Worse, just a few months later, you will again see an upgraded version of the car you bought.
b. Personal Loan for Consumption:
With the easy availability of credit at your fingertips, almost all white goods, gadgets, mobile phones, vacations and even your online shopping is driven by easy credit. Debt has become an integral part of our spending. The risk in all this is that we end up buying possessions and experiences which we would have easily avoided had it not been for the easy availability of credit which often have high-interest costs. Over time, such a lifestyle eats into your savings potential and it would impact your wealth creation journey with the possibility of you getting burdened with accumulated bad debt. Credit card debt is of the worst kind with the highest interest rates.
The Bottom Line
Before taking on any debt, you should ask yourself, what is the total cost of ownership, the down payment required, the cost of interest over the life of the debt, and the benefits /outcome of the debt? You may also explore the opportunity cost of the money, meaning what next best option you are giving up by making this choice. With rational thinking, the right questions and patience, you may likely avoid mistakes and make sure that the debt serves you rightly and does not end up being a burden.
