One of our Cari$ Rules for Financial Freedom is to “Be debt free” because we believe real Financial Freedom is only achieved when you are debt free. Put another way, we recommend individuals treat debt with a healthy amount of respect (if not fear), eliminating it quickly, or avoiding it whenever possible. But if we look around, many people use debt freely, almost as if there were no consequences. In this, and a few related posts, we explore different aspects of debt, so you can properly evaluate if taking a loan is the right decision for you.
Let’s begin by stating we are not suggesting that you should never borrow. On the contrary, debt is a powerful tool if used correctly. In fact, you should ALWAYS ensure you have credit options available (e.g. credit cards, lines of credit, free assets that you can use to secure a loan, etc.). But having it available does not mean you necessarily need to use it.
Reasons for borrowing
There could be several good reasons why borrowing is the right option.
- You are buying something that creates long-term value.
- You are buying an asset with a long useful life that could earn income, so you are essentially matching the income with the loan payments
- You have an investment opportunity where the income earned will exceed the interest cost.
- Emergencies e.g. illness, loss of assets, etc. While a proper personal financial plan should have eliminated the need to borrow for most emergencies, the emergency could have happened before you were fully ready, or you may be supporting family members through their emergencies
- Your cash is temporarily unavailable (e.g. invested), so you need to smooth out your cash flows
Problems with debt
While good reasons may exist for borrowing, this does not change the fact that debt has several associated problems:
- It is restrictive. You now have a legal obligation, and are accountable to, a third-party who sets rules for you to follow. All your personal financial decisions now have be made within this context.
- It ties up assets. When you are required to secure your loan, you have now effectively lost control over the item used as collateral.
- Most persons cannot evaluate how much is too much debt. If you are not in control of your finances, it is easy to over borrow. We discussed this at length in the posts How Much is Enough Debt – Part 1 is and Part 2.
- When your debt level is too high, small decreases in income can create tremendous stress.
- Personal loans are expensive. As a riskier form of lending, the interest rates on personal loans tend to be higher than most loans.
- There is a greater likelihood that debt will reduce your net worth than increase it. We explore this below.
Why our apparent comfort with debt
Despite the associated problems, it appears a casual approach to debt is sometimes taken for a few reasons:
- Credit is relatively easy to obtain. Because it is fairly easy to borrow, it encourages us to satisfy our wants by an immediate purchase rather than saving up for an item over time.
- Whether due to the relative ease of accessing credit or otherwise, we are faced with a cultural shift where being in debt is more acceptable to the current generation compared with the previous generation.
- We delegate our decision making to entities that are selling loans. Because we have a demand to borrow, our primary focus is not always properly evaluating how much debt is truly enough for our financial situation. We therefore look to our lenders to tell us how much we can afford. Unfortunately, we forget lenders are selling loans; this is their business. As a general principle, do not blindly follow advice from someone selling something. You need to be in control financially and make your own decisions. (Check out the post How Much is Enough Debt – Part 2 to learn more)
- Persons may simply not understand the credit products they are using (e.g. credit cards, hire purchase loans, etc.), their associated cost, or if cheaper and more flexible options are available.
Impact on your ability to create wealth
Firstly, let’s agree on how wealth is defined. It is not necessarily how much income someone earns or how much assets they appear to have. (Do not judge based on appearances.) Real wealth is demonstrated by your level of net worth. Creating and building wealth is about growing your net worth, a concept that applies even to persons of limited means.
You obviously want this to be a positive number, meaning more assets than debt, and you also want this to grow over time, because this is the pool that you’ll be using to fund your post-retirement lifestyle. The way most individuals grow their net worth is by increasing their level of savings (keeping more of their money). Another way is by reducing debt.
Debt has a cost
The cost of debt is the interest that you pay, and interest rates on most loans to individuals tend to be relatively high. Interest is no different from any other expense like food, rent, or utilities: if uncontrolled, expenses reduce your savings, and consequently, your net worth.
We sometimes ask persons with debt what is the rate on their loans or the amount of interest they pay in a month or a year. It is astonishing they are usually unable to answer. When they check, they are shocked at the amount of interest paid, as a percentage of their annual savings…
Good debt vs Bad debt
Debt can either create or destroy value. Good debt could be called “Investment” debt because it could create more wealth in the long run (it could increase your net worth). On the other hand, bad debt could be called “Consumption” debt because it was used to purchase something that only has immediate value or loses value over time (it reduces your net worth).
Your best investment strategy
For many of us with debt, our best investment is usually to pay it off as quickly as possible. If you have both a loan and surplus cash (savings), you simply need to ask yourself if your surplus cash can be used to earn a higher return than the interest you pay.
For example, let’s say you have a loan at 7%. You save a little each month, but the only place you can invest will pay you 2%. If you use those free funds to pay down your debt, you are actually saving yourself (7% – 2% =) 5%. So instead of loan interest eroding your net worth over time, you can improve your net worth by saving the interest on the loan portion you repay early.
Check out the post APR – The True Cost of a Loan is to learn if your loan is costing more than you think.
The reality is because most personal loans are expensive, repaying them as rapidly as possible is almost always the best financial decision for individuals. Hopefully the comments in the Cari$ Rule “Be debt free” now make a bit more sense.
You may be wondering if there are circumstances when repayment is not the best option. The answer is, yes, and examples include:
- Your loan is at a subsidized rate, so the low rate makes the loan beneficial
- The interest expense has a favourable tax treatment (only really applies to businesses)
- The loan proceeds are invested to earn a higher return than the loan interest rate
For most individuals, debt is a solution wrapped up in barbed wire. Do not rush to embrace it; keep it at arm’s length. When you decide to inch closer and accept its friendship, make sure it is on your terms and for the right reasons. Don’t forget to check out the follow up posts Good Debt & Wealth Creation and Bad Debt & Wealth Erosion.
We hope you found this post useful. If you have thoughts or experiences to share, we’d love to hear from you in the comments below!