CFO of Life #19 - Debt 101: Understanding the Basics

You might have heard the Josh Billings quote "Debt is like any other trap, easy enough to get into, but hard enough to get out of".

This is a slightly grim way of looking at debt, but seeing it that way often helps people, because it can keep potential financial problems at bay. However, it doesn’t do it complete justice, as debt can be a good tool to help you make a huge leap in life.

Debt is one of those things that we all know of, but don't understand well. It is also something most of us will use at least a few times in our lives, but not everyone takes the time to learn about it.

So, is debt a good thing? Well, this is all dependent on your vantage point and the reason why you take out a loan, for example. In my case, my student loan was a good investment and I am still reaping the benefits.

A properly timed mortgage loan is also definitely worth it. There are plenty of people who have managed to use it and buy their first house or even start their own real estate business – buying multiple properties without having the money to outright buy them.

Simultaneously, there are plenty of examples where people have suffered from bad debt, often as a result of not thinking twice about what they are buying and if they need it. They never check the interest on their loans, and in some cases, it can be way over 25-30%. Even worse, we might expect more "horror stories", as we are at an all-time high level of credit card debt. But, let's learn how not to be part of the bad statistics.

What are the elements of debt?

There are four components to debt. They are quite straightforward, but it is good to make sure that we all start from the beginning and build up.

*Principle – The total amount you take out, ie. the money you receive

*Interest rate / APR – The percentage of interest charged on a monthly/ yearly basis

*Payment – Your monthly payment amount

*Total cost – The total amount you repay for the loan

*Duration – The period of time you have to repay the loan

What are the most common types of debt?

To be honest, I will be surprised if you don't recognise most of them, but here they are:

Student loans – to pay for your university education

Mortgage – to cover the cost of your house

Auto loan – to cover the cost of your car or motorbike

Credit card – an open loan that a credit card gives you to use at your discretion

Payday loan – a small loan to cover you until the next paycheck

Overdraft – a small "loan" that your bank would grant you in case a payment has to go through your bank account and you don't have enough to cover it

Line of credit – essentially a credit card, but for business

What do I need to consider when taking on debt?

It depends on the loan you are trying to take. For a mortgage that would be the current economic cycle, the interest rates and the property market. For a student loan, it usually only depends on when you will go to university and what you are going to study.

But in general, it is worth understanding "WHY" you are doing it. What is your purchasing intent? Are you just buying it to fulfil your itch or do you genuinely need it? Is this the right time? Is this the right loan? Is this Annual Percentage Rate (APR) too high? How much would I repay at the end of the loan?

I know it might sound trivial, but believe me, it is worth asking yourself these questions. Because if you don't and you take a bad loan, it can haunt you for a long time! This is why you should consider looking at those elements before taking a loan:

What is the APR?

This is extremely important for credit cards as they can have rates between 20-30% and some go even above 100%. Just that one element can save you a lot more than anything else further down the list.?

Would your rate be Fixed or Variable?

Knowing if your interest rate is fixed or variable is as important as the actual interest rate.

This is more relevant for long-term loans such as mortgages, student loans or auto loans. If the interest rate is fixed, you can easily calculate the total cost of the loan. Doing so for a variable loan is extremely hard.

Also, if there is a sudden spike in interest rates, that can also cause a lot of trouble. It can easily double your monthly payment, and to be honest, this is not something most of us can afford to pay. This is why variable interest loans are tricky. But if the interest rates are low, you will also benefit from that.

What is the repayment schedule?

One thing that a lot of people underestimate is the repayment schedule. This is the diagram which shows you how much of your payment goes towards the interest repayment and how much towards the principal payment. That would show you when you are actually going to start “buying” the asset from the bank.

Would you be allowed to repay the loan earlier?

It might come up as a surprise, but not all loans can be paid in earlier. And again, this is true for long-term loans. The reason is that if you contribute more from the beginning of the loan, you will actually reduce the total value. As every additional $ above the monthly payment will reduce the interest that will accumulate on the loan. But, if you can do it, it is definitely worth doing so as you would drastically decrease the total value of your loan.

Those are usually the biggest “catches” that most people fall for. And they must be reviewed before committing to the loan. There are still? few more things that you should consider before taking a loan.

What else do you need to understand before taking any debt?

What is your credit score?

That is your credibility with the bank. They determine how “credible” you are and how likely you are to repay your loan. The higher your credit score is, the better credit terms you will receive.

What is your equity part of the loan?

Simply, how much do you own from the asset that you are buying? If this is a mortgage, you might be committing to a 10-20% down payment. That means that outright you own 20% of the house. And any subsequent month will add more and more to your equity.

What is your debt relative to your income?

This one is straightforward – what percentage of your income is your monthly payment? A healthy amount is between 10-35%. Anything above that goes into “risky” territory. Because a sudden drop in your income might mean that you can’t pay your loan.

This is what your bank would use to stress-test your loan. This is also the mechanism they use to predict which loans will probably go “bad”. To prevent that, I would aim to have a monthly payment equal to 20% of your income.

I know that talking about debt is not the most interesting thing, but it is worth making sure you have covered your bases, especially in the current volatile economic cycle. And I promise the next few articles will be really thought-provoking. That’s why next week we will focus on the most currently-debated topic, "Buy or rent, and how to make the biggest purchasing decision of your life!"

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Post #19 in the series CFO of Life?#si ?#personalfinance ?#CFOofLife