By Atty. Zigfred Diaz, RFP®, CSS
Let me first start off by saying that ideally, the best situation is to have no debt at all. I say this because even if there is such a thing as “good debt,” the fact remains that you still owe someone some money and the Bible is always right and makes sense when it says that the borrower is the servant to the lender. However, in this day and age, it would seem that we couldn’t escape the fact of debt. Some things are better off to be paid using credit cards, or taking out a loan rather than paying in cash as this gives you some certain advantages.
Before going through the main points of this article, I would like to discuss a basic rule that everyone should know when it comes to personal finances. I am talking about the Rule of 72. Most of the time this rule is commonly used to determine how many years it will take for your money to double in an investment. The equation is simply this, 72 divided the interest rate equals the number of years it takes for your money to double.
But the usage of the Rule of 72 is not only limited to investments. The Rule of 72 can also be used when it comes to managing debt wisely. The Rule of 72 could be written as follows:
72 / interest rate = number of years for your debt to double
By using this simplistic equation, you can take any debt you have, with your credit card, your mortgage lenders and determine how many years will it take for your debt to double.
As an illustration, let us use credit card interest. In the Philippines, credit card companies charge about 3.5% per month. This is about 42% per annum. Using the Rule of 72, it is now possible for us to know that credit card debt doubles every 21 months. (72 / 42 = 1.7 years or 20/4 months).
How does this information help us? This gives you an idea on how fast your debt is growing. Now that you know that your credit card debt doubles every 21 months, you will be more conscious about debt, more knowledge about how the factors such as interest and time play their part in the wise management of debt.
THE GOOD . . .
Now that we are armed with that knowledge, let us discuss good debt. Good debt is generally defined as that which generates income and increases your net worth. The projected income produced by good debt must be conservative and that the said income must be higher than the amortization made. It’s that simple and that logical. In finance parlance, this is referred to as “leveraging,” which means to simply borrow money at a lower interest rate and using the said money to generate higher returns.
Take note however that “good debt” can easily become bad debt if not managed well. How do you prevent good debt from becoming bad debt? Here are some practical advices:
- Be conservative with your estimates. You can avoid good debt from becoming bad by being conservative with your estimated rate of return. While rate of returns vary depending on an investment and varies from time to time, you will need to have an idea on the annual average rate of return for certain investments, and these are somewhere from 3% to 7 % for bonds, and 8% to 15% for stocks. Anything above 15% is for businesses. The average rate of return on equity for publicly listed companies is somewhere from 15% to 30%. While it is true that some companies earn rates of return beyond 30%, it is good to keep your estimates within the range of 15% to 30%.
- Know what you are getting into. I know of a couple who got a loan from the bank using their family home as collateral. They got close to seven million pesos as loan and invested it in a supposed investment that is purported to give a return of more than 30% per annum. Since the bank loan interest is only about 10% per annum, they figured out that it is good to leverage their house, as they will have a net gain of around 20%. The problem is that the investment went bust and the bank almost foreclosed their house. It is still being debated up to this day whether the investment they were offered was a scam or not. But the lesson here is that they only had a vague idea of what they were getting into. They were offered this investment, which at first glance seemed very shady. They did not investigate and do their homework. In my opinion, the way the supposed investment was structured, it was most likely a scam, although they insist that it is just a business that has gone bankrupt.
- Don’t be too greedy. Oftentimes, good debt turns bad because we put them in investments where we expect very fantastic returns. The general rule is that the higher the returns, the higher the risk will be. Using debt as leverage in the hope of earning fantastic returns is oftentimes done because of greed. It is a good idea to have a comprehensive personal financial plan so that you will not chase after fantastic returns. If a return on investment is sufficient to reach your financial goals, then be content with that.
THE BAD . . .
Bad debt is of course the opposite of good debt. These are debt that do not generate any income and does not increase your net worth. The following are practical tips in order for you to avoid bad debt.
- Pay in cash whenever possible. If you have cash to purchase a car, why should you pay interest? But if you think the money you use to pay to buy a car in cash can be invested at a higher rate of return than the interest for a car loan, then go ahead (this is one form of leverage). But whenever possible and if there is no compelling reason or advantage for you to be in debt, then it is advisable to pay in cash instead.
- Avoid depreciating assets as much as possible. Depreciating assets are generally lumped in the category of bad debt. Some people might argue that obtaining a loan for a car is not bad debt as the car is used to generate income. Well it may be so. But if it is a luxury car and you barely can make ends meet, then that is a different story.
- Live within your means. Know how much you earn and how much you can afford to spend. Live within that budget. Having a comprehensive financial plan is always a wise thing. It helps you live within your means, and informs you how much to spend and save. It helps you avoid getting into bad debt.
. . . AND THE UGLY
Earl Wilson once said, “Today, there are three kinds of people: the have’s, the have-not’s, and the have-not-paid-for-what-they-have’s.” Those caught in the sink hole of debt belong to the last category. Make sure you are not one of them!
But what if you are already in an ugly situation, what if you are already deep in debt? What are specific strategies and way in order for you to get out of this sink hole?
- Condonation. While it may be rare to find a lender that would give you absolute condonation, a lot of lenders do give you partial condonation. Considering that most debt has ballooned to unreasonable levels because of interest charges, lenders, most especially credit card companies would agree to condone even as much as 80% of the total amount you owe them. They agree to this, as this is so much better than not being paid at all. Of course, they would not condone the principal, but it is sure that they will reduce the interest charges. It is just a matter of being honest and frank with your creditors and negotiating effectively with them.
- Consolidation. If you have several debts, it is much better to pay off the smaller ones first starting with the ones that charge the highest interest rates. This will greatly reduce your stress and give you some sort of psychological boost that you are on your way to becoming debt free. Targeting the ones with the highest interest rates will help you save money. Taking out one single debt and repaying everything off is also a way to go if you have several debts. Just make sure the debt you have taken to pay off your other debts has a lower interest rate.
- Refinancing. Some lending institutions and even banks offer an interest rate of 0.99% to 1.5% interest per month. This is much lower than what credit card companies charge. Use the loan to pay off your credit card debt, and resolve to never ever again use your credit card except if you can pay it within 30 days. That way, you won’t be charge the monthly interest. By borrowing at a lower interest rate, you will minimize your losses due to interest. Borrowing from somebody with 0% interest is even much better (a rich relative perhaps). If you have several credit card debts, borrow enough to pay all of it. This way you can focus on paying only one debt and one interest rate.
Most credit card companies have a wonderful feature called “balance transfer.” This simply means you transfer your credit card debt from one credit card company to another. When you transfer your balance from other credit cards they will give you only 0.99% interest per month (or in some cases even lower). This is already a steal deal. Balance transfers are payable in terms like 12, 24, or 36 months. What’s good about this is that most credit card companies offer no-fee balance transfers.
So, let’s say you have a credit card debt of P100,000 with credit card A, and you have another credit card, which we will call credit card B. Your credit card B has a credit limit of P100,000. What you could do is you could transfer your debt from A to B. Instead of being charged 3.5% interest per month for your credit card debt by credit card A, credit card B will only charge you 0.99% per month (about 12 % per annum). Credit card B will add the monthly interest and then divide that with the term that you wish to avail of. For example, you wish to pay off your debt within a year, the computation would be: interest multiplied by principal+ principal divided by 12. So that would be 12% x P100,000 + P100,000 / 12 = P9,333,33. Your credit card debt will then be only P9,333.33 per month. (Note: computations among credit card companies may vary, this is just for illustration purposes.)
If you say that you will just stick it out with credit card A and pay P9,333.33 per month at 3.5% per month anyway that is based on “diminishing interest” (this means that your interest goes down if your principal goes down) as opposed to paying a “fixed interest,” you will still end up with P14,822.00 in credit card debt at the end of the year. However, if you do a balance transfer to credit card B and pay P9,333.33 a month, at the end of the year you will end up with zero debt.
But if you pay only the “minimum” per month, what will happen? If you do the math, you will see that at the end of 12 months your credit card debt will still be P92,585. That is why it is not wise to pay only the “minimum.” It is best to avail of balance transfers.
Now, there are several things to remember about balance transfers:
a.) A balance transfer is subject to approval by your credit card company.
b.) The maximum amount you can avail of is your credit limit or a portion of it. Let’s say you have a credit limit of P100,000 and you used up P50,000, you can use a portion of your remaining credit limit to balance transfer your debt from another credit card. However, take note, this is not guaranteed. This is still subject to approval by your credit card company.
c.) Make sure you pay the fixed monthly installment. In our illustration above, pay the P9,333.33 religiously, otherwise it will be made subject to the 3.5% monthly interest. Don’t be tempted to pay only the “minimum” since you will be charged with 3.5% interest over and above the 0.99 % interest. If you will only pay the minimum you are subjecting yourself to double jeopardy!
d.) It is advisable not to use your credit card when you are using your card for balance transfer to avoid confusion and to make sure that you can make it a priority to pay the installment for balance transfer.
e.) Resort to balance transfer only when you cannot avail of the first option. The first option (get a loan with a lower interest rate) is still the best.
- Restructuring. Oftentimes, the debt cycle becomes never ending because the monthly payments are too heavy and considering that there are necessary expenses that need to be met, new debt is incurred to pay off all debt or to finance necessary expenses. Personal financial planners say that only less than 30% of the total income should be used for debt servicing. Anything beyond that would result to a never-ending debt cycle. Restructuring means to negotiate for terms with your creditors to extend the time allotted for you to pay your debt in full and to ensure that you could afford to pay the amortization, that is you can survive without incurring any other additional debt.
So there you have it! Good debt, bad debt and the ugly side of debt. There is no neutral ground, debt could either be good, bad, or could become ugly, and the choice is always up to you. If you are about to incur good debt, make sure it doesn’t become bad. If you have a habit of making bad debts, it’s time to end such bad habit. And if you are in an ugly situation now, fear not! It will come to pass. Don’t lose hope.
Problems are called problems because they have solutions. It’s just a matter of sticking to the game plan of condonation, consolidation, refinancing, restructuring, and being disciplined when it comes to your spending habits and debt repayment. And above all let me stress the importance of a comprehensive financial plan once again. Having one in the first place will help you avoid good debt that turns bad and bad debts that turn ugly.
Atty. Zigfred Diaz is a Cebu-based Registered Financial Planner (RFP) and Certified Securities Specialist. He is currently the director for training and research for CERTA Inc., a Cebu based personal finance, family estate planning, and investment advisory company.
This story was originally published in the October-December 2017 issue of MoneySense.