Is Debt your Friend or your Enemy?

Good debt vs bad debtWarner Bros called me the other day to discuss me speaking at a potential documentary on debt. I had an hour-long conversation about ways to avoid debt, how to get out of debt and personal finance matters.

Unlike many normal people, I’m fascinated by the subject! Am I so boring? ūüôā

Although I’ve never been into debt myself, I have seen the problems it can bring first-hand through my family’s recent history. The fact that people are¬†drowning in debt is not always their fault. Sometimes it’s due to society values or peer pressure or simply, being bad at managing our wallets. Despite that, it’s our ultimate responsibility to get out of bad debt and protect ourselves against that.

When debt is your friend

Not all debt is bad. Which is a very important point in understanding debt itself.

Educating yourself on debt is actually better than making more money.

When a small business takes a loan to buy a minivan and expands their business, it makes a reasonable decision. The business will be stronger and stronger profits will pay for the debt. This is called good debt.

Similarly, when the bank helps you to buy a rental property, you get the flat at a fraction of the real price and can rent it out for a high price. Tenants pay you rent, you pay the bank some money and you keep the surplus for yourself.

Debt is your FRIEND because your money grows while it shrinks. Good debt helps you leverage your earning power.

When debt is your enemy

Debt burden

Usually, though, people see debt as a trade for pleasure. College kid graduates and borrows ¬£2,000 to go on holidays. “Life’s short, I will pay later”.

It’s not only the college kid. Throughout our lives, people pay 18% interest to buy a car on finance. You just bought a depreciating asset and now debt is your ENEMY.

Taking on bad debt means that the money you make work against you not for you. I’m happy when people take debt because my peer-to-peer lending accounts grow faster. This may sound¬†mean but hey, if that’s what people want to do I’ll not prevent them from doing it.

Bad debt is very risky when taken early in life. My manager just bought a ¬£60,000 Tesla car. He’s 50 years old, he owns his house mortgage-free and his finances are in a good shape. I know that a new top electric car will make him happier.

Although I don’t agree with the decision to buy a super expensive car just to drive around once a week, I can understand it. IT’S OK for him to buy a new Tesla on 3% finance because the impact – given his salary and his situation – will be small.

IT’S NOT OK for someone who’s living paycheck to paycheck to buy the Tesla just because someone approved their loan. There are huge risks. Oh yeah… The risks.

The risks of bad debt

Debt will become more expensive

For the past few years debt has become very cheap and accessible. This is both good and bad. It’s very easy to get money because interest rates are very low.

This is where the tricky part is, though. Because interest rates are very low (0.5%), the debt will become more expensive if interest rates rise in the near future. By the way, the Bank of England decides what happens to interest rates, not us.

Just to give you an example, A ¬£450,000 mortgage with a ¬£50,000 downpayment currently costs ¬£1,907 per month at 2% interest. If interest rates rise by 2% in the next 5 years, the next “fixed 2-year term” negotiation will cost you ¬£2,375.

I’m not saying don’t buy a house. I’m saying if you will,¬†know that you should have a margin of safety because borrowed things will become more expensive in the near future.

Stopping you from achieving financial independence

You prevent yourself from getting ahead on the journey to financial independence. Instead of getting a free salary by having invested money working for you, you suffocate it. You have your money working for someone else – the lender!

Having future regrets

How many times have we thought: Oh this was a stupid decision spontaneously taken. I wish I could go back in time and revert it.

Now is that time. Make debt your friend, not your enemy!

How to avoid debt

How to avoid debt

You may already have debt or consider taking some. Regardless of your current situation, If you follow the steps below, you’ll save yourself from future troubles.

1. Start recognizing good debt from bad debt

You know when you’re buying something that will increase in value. For example, a home usually increases in value with inflation and market demand. Taking a loan to buy a house is not as bad as taking a loan to buy a depreciating asset, like a motorbike.

Credit card balances is another form of bad debt because they’re usually used to buy consumer goods half of which go out of fashion 6 months later.

2. Validate your business idea before taking on any good debt

Good debt can easily turn into bad debt if not managed correctly. For example, you take a loan to buy the van for your business. Meanwhile, your sales drop and you cannot pay it back.

I still remember a story I heard about 2 friends who wanted to start a transportation company.¬†They wanted to take a bank loan to buy two coaches. The bank was happy to give them a ¬£30,000 loan as long as they put their parents’ house as collateral. An extremely risky proposition!

What they could have done instead, is to first check if the business idea is going to fly. How? By renting their friend’s bus for a few weekends and paying him a commission. That way, they can reduce the risk of taking a huge loan for something they don’t know it’s going to work or not.

Not all problems are solved with money. Try to see if taking good debt will indeed help you leverage the gains. If yes, I’m all in.

3. Avoid lifestyle inflation

Lifestyle inflation is an interesting one. As people get higher salaries they think they’ll become happier if they spend more. What do you mean, Michael? It doesn’t work like that? No, it doesn’t.

Ask yourself first: Will it make me happier?

Science says that just because you will spend more it doesn’t mean you will get more happiness out of it. Having a social circle and friends, being proud of yourself (self-respect) and staying healthy will make you happy.

But speaking of debt, people that earn more can also BORROW more. They’re more creditworthy because they make more money. This is a double-edged sword.

Because you have more money it doesn’t mean you can put yourself deeper in debt simply because you’re more creditworthy now.

I fell into this trap when I doubled my salary. I could suddenly borrow a lot more and I almost bought a house at the peak of the London housing market.

4. Track your spending

Monzo Budgeting screenshot
Monzo budgeting

Knowing how much goes in and out of your bank account is hard given the old banking systems. Plus you make hundreds of transactions every month so it’s hard to track.

Luckily, you can use something like Monzo which tells you how much you spent every month.

You know what your salary is so no excuses there. Monzo is quite good at categorizing the expenses too.

Too many restaurant dinner outs this month? ūüėČ

 

5. Reconsider education

There is a reason my “How to become a software developer without a degree” article is so popular on Google.

People have started realising that the £50,800 average student debt is not so necessary anymore. Especially for those of us who want to study something technical like software engineering or digital marketing.

I am fascinated by the amount of information that exists online for free. There are so many courses one can take, often from reputable universities like Stanford. This wasn’t the case 10 years ago. I hate seeing students graduate on a big negative net worth after 4 years of study.

Universities have become businesses and the internet is about to put them out of fashion.

Best practices

If you’re already in debt, the path to Financial independence has lots in common with paying it off or avoiding it in the first place.

It’s based on simple life principles like saving some money for a rainy day, don’t live paycheck to paycheck and guess what: Treat bad debt like an emergency.

By now, you know the basics on good versus bad debt and you’re more educated. What is your next step? Let me know in the comments!

4 COMMENTS

  1. I thought it’s done deal and you bought now I undertand you didn’t?
    Do you have some plan for next couple of years regarding your housing?
    I want to move closer to capital next year, also move my family so I’m pondering this currently. Buy or rent?
    If I buy I will have to reduce my teething portfolio, on the other I cannot imagine renting as I own the property now.

    • Hey Alch! I almost bought a house back then, but then we backed out and we didn’t buy in the end. I don’t have any intentions to buy for the next couple of years, especially now that rents are not going higher. Also, maybe in 5-10 years, I won’t be living in London anymore. What about you?

      To be honest, this is not a black or white decision as it really depends on your circumstances. Yes, housing in London is very expensive, yes, there’s instability ahead of Brexit but there are other things that come with owning your roof. These can be the quality of life, status, the freedom to make your own changes, how long you’ll stay in the capital etc.

      Which is why I’ve written a whole article on the subject.

  2. Yes there are some variables and it’s not black and white. We don’t have that extreme ratios of property prices/salaries. But rent is around 700‚ā¨ a month which is higher than my mortgage would be. I want to move my family first in rented place for 1 month and we will see if we like it there.

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