When your expenses are higher than your income, and you don’t have savings, you’ll have to use debt to fill the gap.
Some wealth creation spruikers say there are two types of debt: good and bad. But make no mistake, all debt is dangerous and should only be used in well-controlled and astutely managed circumstances.
In fact, debt-free should be your ultimate goal, because you’ll never go broke if you don’t owe money.
Here’s some more information about debt you can use to improve your financial literacy.
What is debt?
It’s easy to think that debt is simply the amount of money you’ve borrowed and have to repay. However there’s a bit more to it than that.
Have you heard of the debt-time connection where you borrow dollars but owe time? It explains how borrowing money is like reaching into tomorrow, grabbing hold of income you haven’t yet earned, and spending it now.
The consequence is that you need to work tomorrow to repay yesterday’s consumption which is how more debt equals less free time.
Bad and worse debt
I advocate that there are two kinds of debt: bad debt and worse debt.
Bad debt is something you get into temporarily. I call it ‘bad’ because the consequences of mismanaging it are, well, bad. You could face financial hardship, maybe even financial ruin.
Worse debt is money borrowed to buy stuff that’s worth less, or worthless, immediately after buying it.
Does that mean you should avoid debt completely? Yes, if it’s worse debt, and maybe, if it’s bad debt.
If you befriend bad debt, ensure:
- It will return a greater gain than its cost
- It must be temporary for as long as it suits you
- You must have a realistic plan for getting out of debt
- The debt repayments are made before you pay yourself.
What about using debt to buy assets?
An asset is something that has a future value, perhaps because it can generate income, or can be sold.
Assets can either be lifestyle or financial in nature: a financial asset is a purchase for profit and a lifestyle asset is purchased for enjoyment.
Sometimes the line between the two can be a bit blurry, so a simple rule to remember is that a financial asset will never be used for lifestyle purposes.
The safest rule to follow is to never use debt to buy lifestyle assets. If you can’t pay cash, don’t buy it.
This is problematic because a home is a lifestyle asset and almost everyone borrows to purchase their home.
The consequence is having to work many tomorrows to pay for it, becoming bound to your job and therefore having less time freedom. If that’s a price you’re willing to pay, then so be it.
If you’re looking to use debt to purchase an investment, then a test to undertake is to compare the asset’s income return (as opposed to its capital return) against the loan’s debt service cost.
Self-liquidating debt is the safest unsafe debt there is. To be self-liquidating, the debt must be used to purchase assets that generate enough realised income to cover the loan’s interest and principal repayments.
Non self-liquidating debt is where the loan service costs are higher than the investment’s realised income. The bigger the shortfall, the higher the investment’s risk.
For instance, if the income return of an asset was $1000 but the debt service cost was $1400, then you would need to fund the shortfall ($400) from other sources.
Death adder debt
Death adder debt mimics the behaviour of the snake that it’s named after. Its danger is largely hidden, and it lures its prey by some seemingly attractive feature.
Before you know it, crunch! You’ve been bitten.
Borrowing to buy assets that depreciate (fall in value) and don’t produce income is an example of death adder debt.
Let’s consider this example:
Helen was drawn in by her local car dealership’s run-out sale. She signs up to buy a new car for $41,000, pays a $1000 deposit and borrows $40,000 on what she thinks is a ‘can’t-lose’ deal with ‘zero per cent’ interest.
Fast forward three years later. If her car has a market value of $20,000 then her ‘investment’ has cost her an effective 17.5 per cent per annum. So much for zero per cent!
Not understanding how debt can bite causes untold financial headaches and lures unsuspecting consumers into debt traps.
Debt is the antithesis of financial freedom
Remember this: using debt and spending money you haven’t yet earned is the antithesis of financial freedom since it makes you more reliant on your job.
The consequence of borrowing to live above your means today is an obligation to have to work tomorrow for income you’ve already spent.
If you hope to ever be financially free, then never get into debt without a plan for getting out of debt.
This is an edited extract from Money Magnet: How to Attract and Keep a Fortune that Counts by Steve McKnight. Purchase a copy of the book here.
Learn more about Steve McKnight at moneymagnet.au