Loan Decisions: Mistakes that Can Affect Your Wealth

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.

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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.

What is ‘Good’ Debt?

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’.

1. Starting a business: If you have done your market research well, have involved professional or experienced business planners and have a good projection of the income potential of your venture, then borrowing to finance this dream can be very rewarding.
   

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.

2. Mortgage: There is a lot of support for the argument that renting is synonymous to throwing money away and statistics show it is possible to own a home via mortgage financing without significantly increasing your monthly housing costs. Better still, you could take a mortgage and earn rental income - that the house pays for itself and leaves you with some surplus to spend. You can even borrow more against your house and finance other ventures.
   

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. 

3. Education: There has been hue and cry over the last few years over the cost of repaying the Higher Education Loans Board (HELB) loans by students over lack of employment post-graduation. Nevertheless, it is generally agreed that the more education one has the higher the chances that they will earn more. 
   

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. 

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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.

What is ‘Bad Debt’?

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;

• You are borrowing to finance consumption: A loan for your monthly supplies or to fulfil an urge e.g. holiday, fancy clothes etc. will likely put you in an unhealthy financial situation. 
• Loans with high interest rates
• Debts with variable interest rates (most critical if the purchase loses value)
• Good debt decisions gone wrong; e.g. poor timing to take a business loan, taking too much education loan for a non-STEM degree etc.
• You have not understood the terms of your debt; especially variable interest rates
• Taking debt when you cannot afford the repayments - if the cost of repayments do not fit your budget or make it hard for you to save for an emergency, health, retirement etc. is probably worth reconsidering.
• Debt for a highly depreciating asset - if by the end of the repayment period the value of what you purchased is much lower than what you have paid, then it may not be worth it - especially if the asset has not been earning you an income in the intervening period.
• Lack of long-term benefit - taking a loan is always a big decision and as such the value should persist beyond the debt repayment period. 

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;

1. Cars -  Indeed, for some of us it might seem impossible to live without cars. Actually, for some professions, having a car can be a basic requirement and as such, it would be inevitable to borrow to fulfil that job requirement since it will be directly contributing to your income. 

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. 

2. Credit Cards: This kind of debt often is regarded as bad debt due to the nature of what people often use credit cards for. If your credit card use is not measured and intentional then you could land yourself into a perpetual debt cycle with little to no value added to your life. 

3. Consumables: As mentioned earlier, good credit is that which increases your net worth. Now, there may be many pathways to this but borrowing to furnish your house, stock up on supplies or go for a vacation is not likely one of them. One interesting deviation is, for example, borrowing to purchase a set of clothes important for your profession - while borrowing to buy clothes is generally considered a bad decision (clothes are actually worth about half of what you pay for), if your career depends on it, then there is value gained from such a loan.

4. Taking a loan to pay off another loan: This is definitely a controversial one. And you have probably done this yourself especially for small-time expenses using mobile loan facilities. Some have literally survived on this model using salary advance facilities and so on. There are also debt consolidation products offered by reputable lenders that help you clear existing debt and save on what interests you would have paid in the future. 

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. 

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Wrapping Up

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...