There are good debts and there are bad debts. A general rule that we can apply to know if a debt is good or bad is to answer the following questions:
1. Will the use of the debt proceeds improve my condition?
2. Are the terms and conditions of the debt fair? Can I really repay the debt and fulfill its other conditions without prejudice to no. 1?
In other words, will the borrower be in a better condition post debt as compared to pre-debt, even after fulfilling the loan’s terms and conditions?
If the answers to the above questions are yes, then it is a good debt. An example of a good debt is a housing loan that you can afford. Your condition will be improved as you are able to buy a house for your family without putting up 100 percent of the cost, so that’s a yes for the first question. Banks normally require an equity portion of at least 20 percent of the cost. To satisfy the second set of questions, your cashflow from your income and other sources should be able to afford the debt service (principal plus interest), without sacrificing your other basic needs such as food, clothing, schooling, etc.
The sub-prime lending era that led to the world financial crisis in 2007 to 2008 abused the housing credit. Both households and major institutions disregarded the tenets of good debt because of greed and ignorance.
The credit card is another example. There are various advantages of using a credit card. For a prudent card holder, the general rule questions above can be easily answered with yes. Advantages include not having to carry around cash when shopping, earning points from the use which have economic values, keeping track of purchases, etc. For as long as you pay the entire outstanding balance each month, you fulfill the two general rules.
Now the abuse happens once you are not able to pay the entire balance each month. The interest rates that credit card companies charge are usurious. Then add the fact that most of the time the purchases made are frivolous things, maybe luxuries that were prematurely purchased. As I always say, buy luxury only if you can afford to buy 10 pieces of it, okay?
I know of a simple cook in a company who was given a pre-approved credit card. Like most clueless recipients of this mighty plastic, he went around enjoying the perks of his new found weapon, buying things left and right and just paying the minimum payment every month. Boy! He was having a ball, even using his card for the purchases of his friends, and just collecting money from them. He felt he had a magic wand, “Just swipe it, and goods and money will flow!” This went on and on, and he was “current” in his payment because he was paying the minimum balance every month. Before he knew it, his outstanding balance had already ballooned to one million pesos! That’s right, the cook is now a millionaire! Unfortunately, his million comes with a negative sign. He was horrified to realize that he had accumulated a debt worth one million, an amount he never imagined to owe, not even in his wildest dreams.
This is now causing him stress and nightmares because he knows it’s impossible for him to pay off his loan. And what was the loan for again? There’s not even a single valuable asset that he can tangibly hold to remember what that huge loan funded. The truth is, most of that million pesos are just the interest and other charges.
Clearly, if all credit card holders would scrutinize the terms and conditions of the loan that kicks in once they fail to pay the entire balance in their billing statement, they will realize that the terms and conditions are not good for them and will just lead them to a condition worse than before the loan.
The horror of bad debts goes beyond credit cards and housing loans. Many years ago, I did a half-day workshop for the employees of a government agency. The Human Resources Director shared with me that their salaries were still given in cash instead of direct credit to employee ATM accounts. When I suggested that they shift to direct credit system in order to nudge their employees to save, she said, “We’re concerned that they might pawn their ATM cards!” I was horrified to hear this. Today this has become a common practice among people who are living from paycheck to paycheck.
Remember, debt is a double-edged sword. It can bring you both benefit and damage. Debt is a privilege that should be handled with care. What happens when you abuse this privilege? It will lead you to a miserable life. Now the roles reverse. The debt which was supposed to empower you, is now oppressing you, for you have become its slave.
Avoid bad debts. And be careful not turn your good debts into bad debts.
Cheers to high FQ!
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ANNOUNCEMENTS
1. The above article is taken from my latest book “FQ: The nth Intelligence.” To read more about debt and other important topics on Financial Intelligence Quotient, purchase the book from us in advance. Please go to FQ Mom FB page (click SHOP), or FQMom.com (click BOOKS) or email us at FQMomm@gmail.com.
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Rose Fres Fausto is a speaker and author of bestselling books “Raising Pinoy Boys” and “The Retelling of The Richest Man” in Babylon (English and Filipino versions). Click this link to read samples – Books of FQ Mom. She is a behavioral economist, a certified Gallup strengths coach and the grand prize winner of the first Sinag Financial Literacy Digital Journalism Awards. Follow her on Facebook & YouTube as FQ Mom, and Twitter & Instagram as theFQMom. Her latest book is "FQ: The nth Intelligence."