A lot has been said about good debt and bad debt but in many cases the arguments used have been extremely simplistic. The most common line taken is that if debt is used to finance an asset that will appreciate in value or will increase your income-making potential it is automatically good, while if the debt will be used to acquire a depreciating asset then it is bad. This theory does not factor in the terms of the loan, the risk inherent in taking out any form of loan, the stage of life and earning potential of the person taking out the loan, etc.
Unfortunately many people have swallowed the concept of “good debt” hook, line and sinker, which has led them to make spectacularly bad financial decisions.
Debt is a tool, nothing else, and as in the case of most tools it can be used well or it can be used badly. What the loan is used for is definitely one of the factors to consider when deciding whether to proceed, but it is only one of many. It absolutely does not make sense to merrily go and borrow thousands of euros to buy a house (even though it is likely to appreciate in value) for your family to live in, if the repayments will be so steep that they will cripple you financially for several years to come. There is no way of putting a positive spin on such a bad financial decision.
Similarly it is totally possible that the decision to borrow money for a “bad” investment like a car that will depreciate heavily over its lifetime is ultimately a good one. It could be that you have enough money stashed away to buy the car but decide to take out a loan because the interest on the loan is lower than the return you are currently making on your investments. Or it could be the case that getting a car will enable you to live in a much cheaper area and the savings on rent will be much higher than the loan repayments. There is a logic to proceeding with such a loan, although of course it is important to factor in other costs such as fuel, road licence, car maintenance, etc. before making a final decision.
Over the 18 years I owned and managed my business I obviously had to borrow money, in the form of overdrafts and bank loans, to finance the day-to-day operations of the organisation, but more importantly to finance investment and growth.
When I started off at 23 I did not have any savings to speak of. In order to finance the working capital requirements of my rapidly growing company I needed a bank overdraft facility. However I was always aware of how risky it was to depend on bank borrowings and when the company finally became self-sufficient and no longer needed the overdraft to finance its normal operations it was a major red letter day for me. It took 5 years to get to that point and 13 years later I still remember the elation I felt when we were in the black and the monthly dips into the red were a thing of the past.
Now that I have sold the business the time has come to take a good look at my family finances and our current debt. The table below summarises our loans, the interest we are paying, what we used the money for, how we are covering the repayments and the impact such repayments have on our annual costs, which is an important consideration now that I am working on structuring our finances so my family will be financially independent.
Loan 1: The journey to our current home has been an interesting one. We started off in a really small studio flat, which we sold and moved to a three-bedroom apartment in an up and coming area, which we also sold and moved again, to a rental apartment in a much less desirable area. It was then that we finally bought the house we have called home for the last 8 years, and this is where we plan to stay. I will be writing a post about how we climbed the property ladder over a period of 10 years but for the time being the lens is on the loan still outstanding on our home.
A home is not an income-making investment, but it does have a significant personal return on investment (PROI), which means that the factors we took into consideration when deciding to acquire our home were highly personal and related to the kind of life we wanted for our family. So far, 8 years down the line, we have not had cause to regret the decision we made – our PROI on this house has been off the charts!
Luckily the financial decisions we made at the time were also sound. The house we bought has gone up in value and has contributed significantly to our increase in net worth. The loan, on the other hand, is insignificant when compared to the value of the home and we can easily afford the repayments.
Should I use part of the proceeds from the sale of my business to pay off this loan? The decision at this stage is that I should not, because the interest is low enough that I am likely to make more money if I invest my cash wisely.
That said it is worth pointing out that the repayments made on this loan make up just under 8% of our annual costs, so one of the options on the table is to make accelerated repayments out of our current salary income with the aim of paying it off in full over the next 5 years.
Loan 2: A few years ago we decided to buy a boat. I was going through a particularly stressful time (see my post about entrepreneurial burnout) and needed some new pastimes to distract me. Getting a boat was attractive because I saw it as a way to spend more quality time with my husband and children. Both my husband and I have mixed feelings about the decision. We have indeed had some very good times on the boat and we reaped a positive PFOI, but not such a great one that it justifies the financial investment we made.
So the boat was perhaps not the best way to spend our money from a PFOI point of view. However the decision to borrow the money instead of using our savings made sense given the financial reality of the time. Our investments were making returns in excess of 7% per annum, so it was logical to borrow the money instead of getting it by liquidating a part of our portfolio.
The situation is somewhat different now. We are not getting the same rate of return that we were making so easily a few years ago, so the 4.5% interest we are paying on the loan is a major negative point. Factor in the fact that the repayments on this particular loan constitute 12% of our annual costs and the decision is an easy one to make. This loan has got to go. Getting rid of it will decrease our monthly outflows considerably, enabling us to save more while we are working and reducing the amount of income we will need to plan for in retirement.
Loan 3: The loan is financing an important element of our long term financial independence plan. A few years ago we acquired a plot of land and we built an office block on it.
This investment gave our net worth a nice boost, but more importantly, it is self-financing. The building has been rented out and the rental income covers the repayments and tax due on the property. While it is not cash positive as things stand i.e. there is nothing left over once the bank and taxman are paid, the building is essentially paying for itself. In 15 years the loan will be paid off in full and at that point the net income from the property will cover 80% of our projected annual costs.
This loan is clearly a keeper. In fact I am currently assessing the viability of investing in another commercial property, but more about that in a future post.
So after considering each loan the decision is to retain loans 1 and 3, while using part of the proceeds from the sale of my company to pay off loan 2. This will reduce our annual costs making it easier for us to save and consolidate our financial independence.
As things stand we are currently saving 34% of our combined salaries. Once we pay off the second loan we will be able to save 40%. Over the years to come we will be able to use some of our savings to pay off loan 1. The ultimate goal is to pay off this loan in full over the next five years, in order to reduce our costs and enable us to save even more.
As for loan 3, we currently have a long-term tenant in the building so I do not envisage that the situation will change over the next few years. We will continue to use the rent to cover all the costs related to the building, safe in the knowledge that our net worth is increasing as the building appreciates in value, and that in 15 years time we will have an excellent source of passive income that will sustain us in our retirement.
So yes, debt is a tool. If used wisely it can turbo-boost your finances and speed up your journey to financial independence. If used badly it can torpedo your financial future. So make sure you think it through carefully before you take on a loan.
It is also important that you keep in mind that what constitutes a winning strategy today can change due to outside forces that are not within your control, for example a change in the tax laws or the state of the economy (see my post about future-proofing your income), so it is important to go through an annual review to assess the viability of each loan and change direction if necessary.