Debt: The Sting in the Tail of Borrowing
How to avoid being crushed
When you take out a loan or mortgage, you are adding to your level of debt.
Debt can be a good thing. For example, with good debt you might be able to:
- Save money
- Improve your lifestyle
- Retire early
- Enjoy life more
- Help your family more
- Provide employment to others
- Etc.
But debt can also be a bad thing. If you incur bad debt, as a result you might:
- Become poor
- Have to keep working beyond retirement age
- Experience stress
- Be unable to help others, or even become a burden to them
- Lose your business or have to make people redundant
- Go bankrupt
- Etc.
The real difference between good and bad debt is the financial impact of what you use the money for.
Good debts are incurred when the money is spent on:
- A saleable asset that appreciates in value, ie: an investment that provides a much greater return than the cost of the debt
- An essential need
Buy a house, or grow a business, is usually good, because you get an appreciating asset. Also, somewhere to live and a job are both essential requirements.
Bad debts are incurred when the money is spent on:
- Something that has little or no long term value: a depreciating or unsaleable asset, or a consumable.
- A luxury or 'want'.
Examples include holidays and clothes.
There are some things you can buy that can be either good or bad debts, depending on your circumstances. For example, a car is a depreciating asset. However, if your are a taxi driver then it is an essential purchase and, whilst the car itself will depreciate, it provides the taxi driver with a return from the business. For a private individual, a car would provide a 'return' if ownership of a car provided a saving on other transport costs greater than the cost of running a car.
Produce a budget
To avoid being crushed by debt, you should have and follow a personal budget, that follow the principles of:
Mr Micawber
This was a character from Charles Dickens' novel David Copperfield, who said "Annual income twenty pounds, annual expenditure nineteen pounds nineteen shillings and sixpence, result happiness. Annual income twenty pounds, annual expenditure twenty pounds, ought and six, result misery." This is a fundamental point of debt management: you should always live within your means.
Cash Flow Forecast
Your budget should look forward at least a year, because you need to take account of large, one-off bills that occur annually, such as you car insurance or tax bill. The amount of money you have in your bank account goes up and down and need to make sure that you have enough cash in reserve to cope with the most expensive time of year.
Risk Management
Financial problems can often be caused by significant changes in your life, planned and unforeseen:
- illness
- redundancy
- divorce
- having a child
- retirement
- etc.
To keep your head above financial water, when these things happen, you need to have contingency plans in place. This might involve building up cash or investment reserves, or having insurances in place to provide money when unfortunate events happen.
Through your budget should ensure that you will always be able to meet all your bills and loan repayments, no matter what circumstances may arise.
Produce a personal balance sheet
A personal balance sheet is simply two lists: what you own (your assets), and what you owe (your debts).
To produce a personal balance sheet:
- Work out all your assets
- list what you own (house, car, investments, cash, share of business value, etc.); these are your assets
- write alongside each asset the "sale value", ie: how much you could get for them if you sold them or cashed them in. For cash, this is simply the amount of cash you have. For other assets such as your house, be realistic about the price you could get if you needed to sell the house quickly.
- total all the sale values to give your "total assets"
- Work out what you owe
- list everything you owe (mortgage, loans, credit cards, rental agreements, etc.); these are your debts
- write alongside each one the cost of terminating them, ie: what you would have to pay if you decided to finish them now. For your mortgage and loans, this doesn't just include the amount outstanding, but also any early payment penalties you may have to pay. However, if there is an insurance element to your loan, you may get an insurance rebate.
- total all the termination costs to give your "total debts"
Your "net assets" are calculated by subtracting your debts from your assets.
Your aim should be for your net assets to be positive and growing. That is, the value your assets should always be greater than the value of what you owe. And when you borrow more money, aim to make your net asset value grow, not reduce.
Summary
- There are good and bad debts, depending on whether you buy an essential asset that provides a good return.
- To avoid being crushed by debt, you should:
- produce a budget: living within your means, planning your cash flow, and planning for life-changing events that will or might occur
- produce a personal balance sheet, and aim to increase your "net assets"
For more help, see our article on practical ways to reduce your debt.
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