DEBT CAN BE GOOD if used wisely. Through its prudent use, you can increase your wealth over time compared to if you avoid debt entirely. Good debt can provide you with a richer lifestyle and a better quality of life.
The basic rules are that debt is good once the value created is more than the interest cost of the debt, and once the borrower can comfortably meet the repayment instalments on a timely basis. Although these are broad guidelines, eventually a person’s disposition in handling the possible stress of holding debt may override that person’s willingness to go into what may appear to others as good debt.
However, specific questions arise about how much debt is good or manageable in personal financing, how do taxes factor in the use of debt, how to consider the time value of money and so on. Handling debt is complex as it involves factual and emotional considerations.
Examples of good debt are:
1. A wisely handled student loan which allows you to increase your earning capacity. Sometimes, through the proper use of a student loan, a person can more than triple their earning capacity.
2. A wisely chosen and handled mortgage which allows you to own your residence eventually as compared to a lifetime of consumption payments for rent.
3. A loan for an investment in a business opportunity which generates commensurately higher returns than the loan interest rate. Once such an investment loan can be adequately serviced during its life and the supported business can generate high earnings for the investor, and the investor also has the added benefit of the satisfaction and pride of a fulfilling career.
Yet, debt has earned a bad name due to the many times it has been handled poorly. Such bad debt results in losses in overall value for the borrower, burdensome levels of debt and sometimes ultimately to bankruptcies.
Here now are ten scenarios to test your understanding of good debt and of the use of credit. Please label each statement True or False:
1. You will pay less total interest on a loan for 24 months of $1 000 at 15 per cent compounded annually than on the same amount for 120 months at five per cent.
2. An occasional missed or late payment will only negatively affect your credit rating for the next year or two.
3. You should be able to service a mortgage comfortably that requires a monthly payment of about 25 per cent of your monthly household pre-tax income.
4. Co-signing a loan that is eventually fully repaid will not affect the co-signer’s credit rating.
5. Carrying a range of debt such as a mortgage, car loan, personal loans and credit card balances can negatively affect your credit rating.
6. Leasing a car is a useful option if you do not have the cash to buy the vehicle or to make the down payment for the car loan needed for the vehicle you like.
7. The best mortgage to hold is a fixed rate one.
8. Once you have the cash available, it is better to pay off a low interest loan than to hold cash.
9. Loans which allow flexible repayments are better than those that do not.
10. If you wish to build long-term wealth, you should avoid debt as much as possible. If you find you need to respond that “it depends”, please set out what may vary your answer from True to False or vice versa, so that we can have a lively discussion of these scenarios over the next couple of weeks.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. She can be contacted at louisefairsave@nationnews.com
This column is sponsored by the Barbados Workers’ Union Co-op Credit Union.