Posted on: 04-06-2015 in Financial Planning
Debt is like fire. If you play with it without caution and underestimate its danger, it has the potential to ruin lives. But if you use it the right way and know what you are doing, it will serve you well and make your life better.
There is good debt and bad debt. Taking a low-interest mortgage to buy a home is obviously different from paying 30% interest on the money you have borrowed to go on an expensive holiday. These are extreme examples, but the line between good and bad debt is often blurred and may be different in certain situations. It is not that a mortgage is always a good idea and credit cards must be completely avoided. You need to consider a combination of factors when deciding about borrowing money and selecting a particular financial product:
What do you need the money for? In general, borrowing money to acquire assets which will generate or increase your income, save you money or otherwise make your life better in the future can be a good reason for getting into debt. Buying a house, starting a business or financing education comes to mind. On the contrary, borrowing money for short-term pleasures such as holidays, entertainment or excessive Christmas presents may not be in your best long-term interest.
As with any other economic decision, the cost is a major factor. Interest rate is usually the main part, but it is extremely important to not ignore the small print and include all the extra fees and other costs. Although financial institutions are required to quote rates including all charges (usually called Representative APR – Annual Percentage Rate), these are often displayed less prominently and the marketing of consumer lending products can be a bit misleading to the untrained eye. £99 per month looks like a bargain, but when you realize these 99 pounds translate to 25% p. a., the deal does not look that sweet anymore. Generally, products such as mortgages or Lombard loans cost less than credit cards (although the latter can have significant advantages when used correctly).
The total size and particularly the monthly cash flow implications must be considered in relation to your net worth and income. Although being an optimist is said to make one’s life better and happier, when deciding about your future ability to repay loans, it’s better to err on the cautious side. Instead of including expected promotions and pay rises in your calculations, think what you would do when suddenly losing your job and having no income for a few months.
When borrowing money you sometimes take risks which you may not be fully aware of. While your ability to repay the loan can be affected by your own circumstances such as illness or loss of income, conditions can also change on the other side. For example, if you have a variable rate loan and interest rates go up in the future (which is a reasonable expectation given the current extremely low levels), your monthly repayment can increase substantially.
Furthermore, if you are an expat, it can make sense to get a mortgage or loan in a different currency. This can reduce your costs in the beginning, but it will also leave you exposed to currency fluctuations.
When you find a product which checks all the boxes above, you may still want to spend some more time looking for alternatives, in order to make sure you can’t get a better deal elsewhere. Keep in mind that all the factors should be considered together, rather than in isolation.