Debt can be good
Debt seems to have gotten a bad reputation in recent times and for good reason – it was the primary reason for the near collapse of the financial system 10 years ago: Banks lent too much money to individuals to buy property who couldn’t afford to repay the debt. Collectively, as they missed their monthly payments, the banks put their property up for sale and a negative chain reaction was set in motion.
But for the individual, debt can be the most important tool for financial freedom and this is not focused on enough. Debt has been good for so many people in the world aged 50+. It is because of debt that they have accumulated so much wealth.
Firstly though, which debt is bad? This is really non-essential debt. Examples are, credit cards, store cards, pay day loans, bank overdrafts.
When you take out debt to pay for your food, clothes, monthly bills, holidays, you are paying your precious hard-earned income across to the shareholders of the banks. One the one hand there is so much anti-bank sentiment for the troubles they have caused, yet on other, they are fed and supported by billions of people who don’t pay of their monthly credit card bill in full.
Credit cards today charge about 30% a year, for any balance not settled. So an £80 pair of jeans bought in sale which originally cost £100, paid on credit card and not paid off for a year will end up actually costing:
£80 x 30% = £24, so total of £80 + £24= £104
Not such a great move then, buying sale price things if you can’t afford to pay it off immediately. You would have been better off not thinking you must buy it in the sale and instead waiting until it was affordable. Full price of £100 is less than the sale price plus credit card interest of £104.
This interest payment of £24 over 12 months is totally lost value for the individual. Ok, you had the pair of jeans in those 2 months, but the question to be asked is why was having them at a cost of £24 worthwhile.
Imagine you bought 5 other items of the same value as the jeans. Over 12 months, you would end up paying £120 in interest.
When is debt good? It’s rare that you will ever read in the press that debt is good. But it can be liberating.
Long term, planned debt for non-consumer items can be one of the best financial transactions you can make as an individual. It can make you rich. But it needs to be thought out.
There are a couple of reason as to how taking out long term debt can make you rich.
The first reason is that the money you are borrowing is not being used to go out and have a massive party around the world, dressed in Versace with your own entourage of make-up artists and psychotherapists.
You are borrowing the money to purchase a non-depreciating asset such as a property.
Property in the UK for the last 30 years has been one of the best assets to have, as well as being a place for you to live in. Despite ups and downs, it will continue to be so for as long as Planet Earth is habitable.
If you spent £50k in 1983, on an average house in the UK, today it would be worth £400k.
And this is one element of why debt can be good. You would have borrowed a maximum of £50k to buy the house. Your loan would have been paid off and you would now have an asset of £400k.
But that’s not the only reason why taking out a long term loan is really beneficial. When you took out the £50k loan – it went into an asset that, on a long run basis, is going up in value. So the money is working for you. It’s generating an increasing asset value rather than adding another rip in a pair of already ripped jeans. As well as that though, the £50k value of debt that you have is actually reducing in real value. This is through the effect of inflation.
Every year of having the £50k of debt, each year it is worth less. If you took out the loan in 1990 and still had all of the debt outstanding in 2015, in 2015 to buy you the same thing you could buy in 1990 with the £50k, you would need £60k.
So the value of what you owe the bank have gone down in real terms, and at the same time the value of what you own as a result of taking out the loan has gone up (massively).
Before we factor interest into all this, you would have made £350k out of taking out the loan, by buying an asset you could not afford to buy with your own means. This is called leverage and is a very powerful financial tool. There’s very little way of making so much money as an individual without the use of leverage.
So long term debt can help you gain financial freedom as long as it is respected and understood.
Of course you would have had to pay interest on your loan, which we can come to in the next section on the best way to manage interest payments.