STOP TAKING LOANS FOR LIFESTYLE

Posted by Zack Mwema.

While it's possible to live completely debt-free, it's not necessarily smart. Very few people earn enough money to pay cash for life's most important purchases: a home, a car or University education. The most important consideration when buying on credit or taking out a loan is whether the debt incurred is good debt or bad debt. From a general perspective, I would say that Good Debt is loan incurred in Purchase of Assets while Bad Debt is loan incurred in purchase of Liabilities.

Robert Kiyosaki, the Author of Rich Dad Poor Dad, defines an Asset as anything that puts money into your pockets or anything that increases your Net worth. He also defines a liability as anything that takes money out of your pockets or reduces your net worth.

Good debt is an investment that will grow in value or generate long-term income. Taking out student loans to pay for University education is the perfect example of good debt. First of all, student loans typically have a very low interest rate compared to other types of debt. Secondly, a college education increases your value as an employee and raises your potential future income.

Taking out a loan to buy a home is good debt as well. Home mortgages generally have lower interest rates than other debt, plus that interest is tax deductible. Even though mortgages are long-term loans (over 20 years in many cases), those relatively low monthly payments allow you to keep the rest of your money free for investments and emergencies. The ideal situation would be that your home increases in market value over time, enough to cancel out the interest you've paid over that same period. You can also take a loan to buy plots or land. While the value of land increases over time, the debt reduces making your net worth to grow considerably.

Loans taken for businesses are also good loans. But one has to make sure that the loan is taken for a business one has already started and understands very well. Taking a loan for a business start up is risky and may leave one’s finances badly exposed.  A new business has its own challenges and so adding to it the extra responsibility of servicing a loan is likely to strangle it to death. It would be advisable to start a business from ones savings or from grants and then take up loans for expansion once the business has stabilized.

Bad debt is debt incurred to purchase things that quickly lose their value and do not generate long-term income. Bad debt is also debt that carries a high interest rate, like credit card debt. The general rule to avoid bad debt is: If you can't afford it and you don't need it, don't buy it. If you buy a fancy,  Kshs 5,000 pair of shoes on your credit card, but can't pay the balance on your card for years, those shoes will eventually cost you over Kshs 8,000 and by then they'll be out of style.

Temporary  Overdrafts or Salary  advance loans are some of the worst kinds of debt. In overdrafts and salary advances, one takes a loan that they pay once their salary for the following month hits their bank accounts. Interest rates for this kind of loans are astronomical, starting at 10% per Month which loosely translates to 120 % annually and if you fail to pay back the amount by your next payday, you incur yet another processing fee to "roll over" the loan. Worse still, if one is not careful, once the loan is deducted, he/she will apply for another advance hence starting a debt cycle that’s not easy to get yourself out of.

The worst loans are loans obtained from loan sharks or Shylocks. In a recent seminar I held, a client told me that he had a problem and approached a Shylock for solutions. He wanted Kshs 20,000, the Shylock told him that he had to pay Kshs 8,000 in advance as interest, this he did and was advanced a loan of Kshs 20,000 to pay the following month. Come end month, he paid back the Kshs 20,000. Failure to pay the money, he would have paid Ksh 36,000 the following month.  So in Total, he paid Kshs 28,000. Simple Mathematics will tell you that translates to 480 % Per Annum.  This is a classic example of Bad debt. Now compare this with another guy, in the same seminar who told me that he took a loan of Ksh 200,000 to buy a plot in an upcoming estate in his local town. He pledged to pay back the loan over a period of three years. By the time he finished repaying his loan, the value of the property had risen four fold to Kshs 800,000.

So before you sign up for that loan, or before you call your friend to ask him / her to Mpesa you some money refundable on end month, ask yourself, do I really need this loan? , is it increasing my net worth or decreasing my net worth? Is it good or bad debt? Though its difficult to live completely debt free, its very possible to live free from stressing and straining bad debts.

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