by Kalu Aja
So this lesson, we will discuss borrowing and debt and how to go about it responsibly.
When you borrow you go into debt, your liabilities increase. Debt increases cash flow, thus your Gross Income rises, but it also increases the expenses on your Non-Discretionary budget via Interest repayments.
In the Life Style approach in financial planning we discussed last week, it is common that from the accumulation phase, say age 20 to 40 years, the net income or net discretionary cash flow is low. At this stage debt is often usually used to acquire assets.
These are two kinds of debt, there is good debt and bad debt.
Good debt is any debt where the interest rate charged on the borrowed cash is lower than inflation or expected investment return. A Debt is also good where the repayment period is less than the expected life of the asset purchased with the debt.
An example of a good debt is a mortgage loan where the repayment period of the loan is shorter than the economic life of the asset purchased i.e. the house.
Bad debt is debt where the interest rate charged is high or where the economic life of the asset purchased by the debt is shorter than the debt repayment period. An example will be a consumer loan of say 30% for 5 years to buy an asset like a stove that has an economic life of say 3 years.
In summary Good debt has a low interest rate, is long tenured and the purpose of the debt has a longer economic life than the debt tenor.
Bad debt has a high interest rate, short tenured and the purpose of the debt had a shorter economic life than the debt.
How to use debt responsibly?
So how do you borrow responsibly? Well we calculate the cost of the loan and compare to the economic benefit from the loan. The cost of the loan is the interest rate; the economic benefit is measured in how that loan adds to your asset base or net discretionary cash flow.
· In general, Debt should be used to increase your net income or your assets. Be careful of using debt to purchase assets that depreciate faster than the loan is repaid.
· The most important thing is to minimize borrowing with an interest element. Thus seek out sources of finance that do not charge any interest eg borrowing from family and cooperative societies. Do this first.
· When you have exhausted all sources of non interest borrowing, you can approach a bank for a loan. Now keep in mind the longer you can spread out the loan payments the better for your budget. A 6-year loan is better all things considered than a 4-year loan because your repayments are lower.
· Also ask your bank if the interest rate charged is fixed or variable i.e. will the rate rise if the Central Banks MPR rates increase?
· Ask the bank about early repayments, are there penalties if you pay down early?
· Also ask for a schedule showing your actual principal and interest payments clearly separated, and any management fees you will be charged. Be very clear on this.
· If you’re borrowing for a business, then only borrow to fund income generating assets. Do not borrow to buy the CEOs “status car”, you can borrow to buy the delivery van. You buy the CEOs car from profits the business generates….
· Also watch timing, don’t borrow short term via overdraft to fund a long term project eg building a new head office. Be careful about borrowing a term loan with a fixed repayment schedule to fund a contract with the state government where you are not sure of exact date you will be paid.
Keep in in mind this simple equation, at 25% interest rate, if you borrow N100 from the bank, you will pay them back N100 in interest alone after four years. bank interest loans are very expensive, this must be a last option.
So we stop here, next week we discuss debt management, i.e. how to get out of debt
Financial Jargon of the week.
A Slowdown, a period of slow but not negative economic growth…
A Recession; a recession is two consecutive quarters of negative economic growth…
A Depression is commonly defined as an extreme Recession that lasts two or more years
Question of the Week Is Esusu aka Ajo, the group saving and borrowing really a good idea?
Let me know what you think
Op–ed pieces and contributions are the opinions of the writers only and do not represent the opinions of Y!/YNaija
Kalu Aja is a financial planner with 17 years experience spanning brand management, private and investment banking, and pension management.
Kalu tweets @FinPlanKaluAja