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By: Tim Bennett
21.02.2020
21.02.2020
Most people take on debt at some point in their lives. However, it is crucial to understand the difference between good and bad borrowing as Tim explains.
Background
Most of us borrow at some point in our lives. The secret to doing so successfully is avoiding expensive debt that can quickly spiral out of control.
Why we borrow
The reasons why personal debt can seem so attractive is that it can quickly plug the gap between what we can afford and what we want. On top of that, with interest rates at record lows, it can seem like a no-brainer as a way of funding our lifestyle.
However, it is this easy access that also makes it dangerous.
Why we shouldn’t
In a nutshell, there are three reasons to be wary as a borrower;
Keeping up with the Joneses
Debt can seem like an easy way to solve fear of missing out (FOMO) and achieving the same as our better paid peers. However, this is a classic trap that can leave people financially impoverished.
The fact that we can all access debt so quickly and easily merely fuels the problem.
How compounding can become the enemy
Part of the issue is that many people do not grasp until it is too late how powerful compound interest can be when it works against them, as it does when they borrow.
Here is a short example, using an annual interest rate of 18%. The “rule of 72” suggests that a credit card debt left to compound at that rate for 4 years will approximately double. Anyone thinking 18% is high should take a look at unauthorised bank overdraft rates that can hit 40% or payday loans where the rate may soar way above even that heady level.
A permanent loss of wealth
The third challenge with debt is that it can lead to bad decision making.
That is because it can start to skew how we view our assets and in particular an investment portfolio – we may be tempted to liquidate shares in order to pay down short-term debt which, in turn, forces us into a form of market timing that can be very damaging to our long-term investment returns.
Charlie Munger, long-time investment companion of Warren Buffett, put it this way;
“Good” debt
So, given that most people need to borrow at certain points in their lives, are there any rules of thumb around what constitutes “good” debt? In short, yes. Here are three types of debt that should not be ruinously expensive. The exact terms will vary in each case – and some readers may take issue with my first example as it can lead to tensions if not managed properly – however all three normally obey some basic rules around affordability and predictability when it comes to cost (i.e. interest and the timing of any repayment of capital).
To find out more
Please feel free to email me on [email protected] or contact an Adviser if you would like to know more about this topic.
