Bad Debt and Good Debt

Check the transcript of the video here:

Hi. I’m Maciej Stanek, Senior Financial Adviser and Director at Véurr. Bad debt is the focus of today’s discussion. Bad debt is simply borrowing money to receive goods or services, that once acquired, cannot be recovered to clear that debt.

An example of this would be to pay for a haircut or a holiday on a credit card. Once the service of getting the haircut has been provided, you cannot reverse that action. If this haircut was paid for by a credit card, which are borrowed funds, then you have to obtain funds to pay back that debt to the credit card company.

Similarly, if you take a holiday, pay for plane tickets, accommodation, and mojitos while using a credit card or a personal loan, then once you return from that holiday, you have to obtain funds to pay back the debt you incurred – you cannot un-fly in the plane or un-stay in the hotel!

Borrowing money in this way means you can pay for goods and services today. Yet future you has a responsibility for paying for those goods and services in the future. This becomes dangerous if today’s you goes overboard with the level of funds borrowed and future you cannot possibly obtain the funds required to pay for all of the borrowed funds of today’s you. There is also nothing to salvage and sell to pay back to the lender.

Bad debts also include loans on assets that depreciate in value. The most common asset in this category is a car.

You might get a car loan of $50,000 for a brand-new car, but as soon as you drive around in that car, the resale value drops below that $50,000 price tag you paid.

If you then sell the car, you may find that the price you get for the sale is less than the outstanding level of debt. In this instance, you have no car, but you still have debt. Even worse. What if you crash your car and it is uninsured or underinsured? You have no car and an even greater level of debt.

That all being said, not all loans are bad debts. If the resale value of the asset you buy using debt holds its value or increases in value, debt can be used to increase your wealth much more significantly than you would be able to do so on your own.

A house has historically been example of this. If you ask someone who purchased the house 20 or 30 years ago what they paid for it, they will most likely tell you a price which is significantly lower than the value of that same house if sold today. They probably took out a loan to buy that house equivalent to the value at the time of purchase.

So, in their instance, worst case scenario, if they had to sell the house to pay off their loan, the higher value of the house would clear the loan and they would be left with some extra cash.

Another example of a good debt can be explained as follows. What if I borrow $100 from my friend Jack and I tell him that I will pay him $5 interest every year that I owe him money? We do this for an undisclosed period of time until I have the original a hundred dollars to pay him back.

Now, if I do this for one year, I would owe Jack $5 in interest and I’d still owe him the a hundred dollars borrowed.

Now, let’s say I go to Jill and I say, ‘Hey Jill, I’ll lend you a hundred bucks if you give me $10 for every single year that you owe me that money.’

Now, if Jill agrees to this, she will have to pay me $10 every single year that she owes me money. And if I take the interest that I collect from Jill, the $10, and I pay back Jack his $5, I’m making a $5 profit on the difference.

Now if I did this for 10 years, I would get $5 profit every year for 10 years, resulting in $50. And I didn’t need to use any of my own money to do so.

This is an overly simplified version of what banks do when they offer interest on term deposits. They use the money from those term deposits to then lend money at higher interest rates to people who are borrowing for things like a house, a car, or the credit card purchases we spoke about earlier.

I hope this shows you that not all debt is bad, but if you’re unsure whether to take on a particular debt, it’s prudent to have a financial advisor guide you so you use debts to your advantage.

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