hThis is a continuation of the posts Be Uncomfortable With Debt and Good Debt and Wealth Creation.

In Be Uncomfortable With Debt we recommended that you should approach borrowing carefully and make an informed decision if new debt is right for you. A major factor in this decision would be the impact of new debt on your net worth: does it add or erode? In Good Debt and Wealth Creation we examined borrowing purposes that would be regarded as “Good” debt, meaning they potentially could grow your net worth. In this post, we discuss borrowing purposes that could be considered “Bad” debt (or “Consumption” debt) because they reduce your net worth.

Everyday consumables

Consumables refer to groceries, clothes, or other discretionary purchases, which have no lasting value and are for either immediate or short-term consumption. These expenses are usually identified with credit card debt i.e. purchases are made using a credit card but the card balance is not paid in full on the due date. (Check out the posts Joys and Woes of Credit Cards and Understanding Credit Card Debt to learn more about credit cards).

Let’s use a simple example to illustrate how this debt could impact your net worth. Remember net worth is your total assets (property, cash savings, investments, etc) less your total loans (mortgage, credit card, personal loans, etc).

Assume you have cash savings of $10,000 and no debt; therefore net worth of ($10,000 less $0 =) $10,000. Let’s also assume you have a credit card balance of $2,000 for consumables, so for $2,000 of expenses you have added debt but no assets.

Your assets therefore remain at $10,000 but because of the debt, your net worth has fallen from $10,000 to ($10,000 assets less $2,000 debt =) $8,000. Actually, it has fallen by more because of interest charges, but we’ll include this in the next situation.

Furniture and Appliances

Unlike the purchase of a home, furniture and appliances are depreciating assets because they do not add to the value of your house; therefore, they will not increase your net worth.

Going back to the initial example, let’s assume you fully financed (meaning, no deposit) the purchase of furniture/appliances costing $15,000. At the date of the loan, your net worth is unchanged because new assets and new debt have the same value:

Assets: ($10,000 + $15,000 =) $25,000

Debt: ($0 + $15,000 =) $15,000

Net worth = $10,000

But over time, your net worth will be eroded by the interest cost that you’ll pay. If you assume 10% for 3 years, your net worth will reduce over time by $15,000 x 10% x 3 years = $4,500:

Assets: ($10,000 + $15,000 =) $25,000

Debt: ($0 + $15,000 + $4,500 =) $19,500

Net worth = $5,500

Remember, assets of this nature lose value over time, so as your debt falls by repayment, the asset values also fall, but your net worth falls more because you also have to pay interest on the loan. For simplicity, we have ignored the effects of principal repayments and asset depreciation (loss of value) on the calculation of net worth.  

Vehicles

A car is not an investment like a home or a business. Yes it could be expensive, but it is not an investment, because it is a continually depreciating asset. (Check out the post Buying a Car.) Unlike furniture or appliances, which have a very long life and lose value fairly slowly and steadily, a car loses tremendous value in the earlier years (approximately 55-65% in the first 5 years).

Returning to our example, similar to furniture/appliances, at initial purchase, your net worth is unchanged. Let’s assume the car cost was $175,000 and it was fully financed.

Assets: ($10,000 + $175,000 =) $185,000

Debt: ($0 + $175,000 =) $175,000

Net worth = $10,000

Over time, however, your net worth will reduce by the loan interest. If you assume 10% for 5 years: $175,000 x 10% x 5 years = $87,500.

Assets: ($10,000 + $175,000 =) $185,000

Debt: ($0 + $175,000 +$87,500 =) $262,500

Net worth = -$77,500 Bad news: Your net worth is negative (your debt exceeds your assets)!

But with a car, your situation actually gets worse, because apart from interest costs, you now have to factor in additional costs that come with a new or replacement vehicle. These costs will further reduce your net worth over time because you will be saving less. We’ll cover this in an upcoming post Buying a Car – Your Budget.

One further problem arises with cars and financing. Because a car loses value (depreciates) rapidly in the early years of the loan, it is very possible that your loan could be greater than the car’s value in the first few years. If for any reason you are forced to sell the car and extinguish the loan, you will need to pay the excess loan from your savings, which will further reduce your net worth.

Best approach

Because borrowing to finance the purchases mentioned above will negatively affect your net worth, the best financial decision is to buy these items cash i.e. save over time for the purchase. Understandably, this could be impractical depending on the items you are buying; therefore, if you must borrow, we suggest:

  1. Make the largest deposit possible to save expensive interest costs.
  2. Search for the loan with the lowest interest rate. But beware: ignore quoted interest rates. Check out the post APR – The True Cost of a Loan to learn how to determine the lowest rate.

Closing thoughts: Additional tax

When you desire to purchase something now instead of saving to buy the item, it is very convenient to think, “I’ll just borrow”. This is most likely because you are thinking that using a loan is the equivalent to paying for the item over time. But instead you should think of the interest on the loan as an additional tax on the transaction and find out what is the total cost of the purchase i.e. cost of the item plus loan interest. Then decide if the total cost is worth the convenience of owning the item immediately, or is it a better value to just wait, save, and buy the item for cash.

In many cases the total cost is not worth the satisfaction of immediate ownership.

We hope you found this post (and the related posts Be Uncomfortable With Debt and Good Debt & Wealth Creation) useful. If you have thoughts or experiences to share, we’d love to hear from you in the comments below!

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Alisha Kissoon

Hi. I hope you enjoy reading the posts! I have nearly 20 years regional and international experience in financial services, and I am passionate about helping others achieve Financial Freedom by making wise financial decisions. Keep coming back!

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