Personal Finance with Meristem

Discerning the Difference Between a Good and Bad Debt

“The way to determine which is which is to consider whether or not the debt is creating a future opportunity or a future problem.” -Jennifer B. Harper, Bridge Financial Planning.

Is debt really good? The answer to this question depends on the individual involved. Typically, what differentiates a good debt from other debts is its purpose and the value derived by the individual taking it on. While several debts are justifiable and taken on with good intentions, the outcome may not necessarily be as planned. Before taking on debt, there is the need to determine its necessity, time of the acquisition, the amount required, the associated costs, and its impact on your financial goals.

Good debt will lead to a good outcome, especially when it is used to purchase an appreciating asset or to make an investment that will improve earning capacity or generate long-term wealth. This may, however, be limited by the resources available to meet the repayments of the debt obligations. General forms of good loans include educational loans, business loans and mortgages.

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Taking a loan to invest in a financial asset such as stocks, bonds or government bills has its downsides, as it can be complicated to track and prove risky. This is usually the case when the investor is a novice in matters and instruments relating to the financial markets. Before you proceed to take a loan to invest in stocks or bonds, a thorough analysis of the investment vis-a-vis the debt should be conducted to determine the level of risk and profitability, given your financial needs and goals.

A student loan is relatively uncommon in this part of the world, unlike in developed countries such as the United States of America (USA) and the United Kingdom (UK) where the concept is prevalent in funding university and college education. It is assumed that the higher the level of education acquired, the greater the chance of a high paying job. For instance, an investment in a Harvard Business School or Lagos Business School MBA combined with other factors should be a Launchpad for better jobs, high paying roles, an international career, and ultimately a better quality of life. An educational loan is expected to be repaid from future earnings, which implies that the degree or certification must be carefully selected, taking into consideration the current job market and future job opportunities.    

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Starting a business requires more than funding. It requires a viable idea that is sellable and can generate positive cash flows over a near future. Once the debt is fully repaid and the business is debt-free, it should become more profitable and valuable. For small businesses, the narrative has changed as there are more forms and ways of raising debt capital. The source of debt must have the cheapest cost and the most flexible repayment terms.

Everyone desires to own a home. Taking out a mortgage to buy a home is always a favourable idea, as it leads to ownership. The more interesting thing about taking out a mortgage is that in most cases the purchased home is used as collateral. In addition to that, the property is expected to appreciate over time, leaving you wealthier when the mortgage obligations are fully met. Mortgages are long-term debt and always require an upfront equity contribution of up to 10-30% of the property’s value.  If you make significant equity contributions coupled with a low-interest rate on the mortgage, your monthly payments could be cheaper than rent.

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Taking a loan can be a good idea when it is well thought out. It affords you the opportunity of taking advantage of offers that you would ordinarily forgo due to lack of cash. These opportunities can be irregular, time-bound and life-changing, this means you must be aware of debt options available to you at every point in time for you to take advantage of them. These opportunities must be properly appraised to determine their risk and viability. The expected returns or gains from the venture or project must cover your cost of debt and leave you with a financial reward that is worth your time and effort. Always tread carefully and cautiously, as the saying goes: “If it sounds too good to be true, it probably is.” It is important to speak with a financial advisor before taking on debt or making an investment decision.

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