In our financial growth journey, sometimes borrowing money can make good sense but many other times too it can cause pain and disconcertion.
In simplistic terms then, ‘good debt’ can help you achieve your financial goals, while ‘bad debt’ can be very expensive and derail or permanently kill them.
We have all probably heard of horror stories told of people taking loans, getting indebted for their entire lives, or worse even committing suicide. Many Kenyans have made fatal mistakes when borrowing that have left them struggling to stay afloat.
If you have been watching the dailies over the last one year, you might have noticed the increasingly high number of auction notices. For example, on its March 29, 2021 issue, the Daily Nation had a staggering 9 pages of auction notices - this, for a newspaper that averages 46 pages.
Such realities have made many ever so afraid of taking up loans to finance their life goals. Certainly, a lot can be said about the argument that no debt is good debt. However, the truth is that for most Kenyans, debt is the only pathway to owning big value assets such as homes, land or starting a business.
These kinds of loans can be easily justifiable in terms of the value the borrower gains, and then there's plain reckless borrowing on the other extreme. Between the extremes is when debt becomes harder to figure out.
While one might still be stuck on the mindset that debt is inherently bad, debt that can be considered an investment falls in the category of good debt. You might have heard of the often-used adage, it takes money to make money.
As such, if you take a loan to buy something that will appreciate in value and increase your financial status, then it is likely that kind of debt is ‘good’.
So, good debt is that which can help you generate income and increase your net worth - meaning debt that can improve your own and family’s life significantly.
Here are some examples of debt that is considered by many as ‘good debt’.
NOTE: If we have learned anything from the increasing levels of auctions and property seizures, then we do know poorly planned business ventures including poor timing, mismanagement and environmental shocks can cause this type of debt to become a bad debt and cost you a lot if not everything.
NOTE: Mortgages are a little complicated for the everyday person and a lot of research and consultation has to be done before making the final decision. Also, with the Covid-19 pandemic and historical volatility of the price of homes, it is important to realise that this too can turn into a bad debt depending on several other factors. You could consider consulting a mortgage advisor to get more confidence in your decision.
But, and this is a big but, all degrees are not created equal - so before taking up an education loan, you have to assess the income potential in the field you are entering into. Careers in science, technology, engineering and mathematics (or STEM) have shown to have the highest income potential - this is what many would generally say, but the decision to take an education loan is entirely up to you and your projections of the value you will get.
On how much education loan to take, the rule of thumb is not to take more than what the total annual earnings of an entry level job in the field would be - that way you can comfortably repay your loan over a number of years without burning your pocket.
Currently, if you are behind on repaying your HELB loan, you risk being locked out of public sector jobs including the counties, for example. So, again, you have to weigh the benefits of taking this kind of loan against the potential disadvantages before taking a loan.
If you are taking a loan to buy an asset that depreciates in value, then you are taking on bad debt - or at least that is how ‘bad debt’ is commonly described. Generally, if the loan you are taking does not lead to an increase in your net worth (either the asset loses value or does not generate revenue), then it would be described as a ‘bad debt’.
Some characteristics of bad debt decisions;
NOTE that sometimes good decisions to take up debt can turn into the worst decisions of your life if you had not looked at the big picture or circumstances change (e.g. Covid-19) as well as volatile interest rates. That is why it is important to understand the terms of your debt very well and negotiate to get the most favourable.
Below are some examples of what would be considered bad debt decisions;
Nevertheless, it is generally accepted that borrowing to buy a car may not be one of the most financially sound decisions you can make. This is because the car will be depreciating consistently while you pay interests on your loan. It is possible to get very low or no interest rates which then would make it a much more worthwhile decision.
The catch is in ensuring that this debt is actually used to clear existing debt and not jumping to further spending. You may think that this is a no-brainer, but many have found themselves in unfamiliar territories as their debt piles up to choking levels.
While we may have divided debt into a dichotomy of ‘good’ and ‘bad’, most kinds of debts cannot just simply fit into either of the categories. Most debts will lie in between depending on an array of factors including urgency or grey areas that may have not been seen at the point of making the debt decision.
Nevertheless, the tell-tale signs of a bad debt decision remain true and should always be considered every time a loan is taken regardless of the urgency of the need to borrow. Because, every loan has to be repaid at the end of the day - the longer you take to repay, the more you will pay back and the higher the chances of your property being seized.
Lastly, bad loan decisions can and will ruin your life’s trajectory - especially if you keep making them. Is it a little of an overstatement? Yes, but adding up these little hiccups along the way can definitely reduce your income potential in the long run.
Is that a life ruined? You tell me...