When you borrow money to meet present obligations, you are consuming future income today. The problem is that your ability to earn is not infinite. If you divide your active life into periods of months or weeks, the periods represents times during which you will incur expenses and will need corresponding income to offset that expense.
Debt present a solution to revenue shortfalls. If a household has expenses of 100 but income of 80, there is an inclination to borrow 20 to ensure that level of income can be met. However, if future revenues cannot pay off the debt incurred today, then a debt trap is created, whereby you are always paying a loan interest but never fully extinguishing the loan. That is a bad loan
So, there is good debt and bad debt?
Good debt is any debt where the interest rate charged on the borrowed cash is lower than inflation or expected investment return. A debt is also good where the repayment period is less than the expected life of the asset purchased with the debt. An example of a good debt is a mortgage loan. E.g, if you get a 18% loan for 10 years to purchase their home. That would be a good debt because the repayment period of the loan is shorter than the economic life of the asset purchased i.e. the house.
Bad debt is debt where the interest rate charged is high or where the economic life of the asset purchased by the debt is shorter than the debt repayment period. For example paying for a holiday with a credit card. The card has a high interest rate and the holiday has no economic benefit (yes it may have health benefits). Another example will be a consumer loan of say 30% for 5 years to buy an asset like a stove that has an economic life of say 3 years.
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How to use Debt responsibly
So how do you borrow responsibly? Well you calculate the cost of the loan and compare to the economic benefit from the loan. The cost of the loan is the interest rate also called the Annual Percentage Rate (APR). The economic benefit is measured by how that loan adds to your asset base or net discretionary cash flow.
In general, Debt should be used to increase your net income or your asset base. Be careful of using debt to purchase assets that depreciate faster than the loan is repaid.
Match Interest to Income
Minimise borrowing with an interest element. Instead, seek out sources of finance that do not charge any or low interest. Examples are borrowing from family and/or cooperative societies. When you have exhausted all sources of non interest borrowing, you can then approach a bank for a loan. Now keep in mind the longer you can spread out the loan payments the better for your cash budget.
Rules for Borrowing
Know your Debt to Income Ratio DTI: It is important to determine your DTI to aid you your decision-making as regards debt. To get your DTI, simply do the following:
- Calculate all your monthly debt payments. .
- Calculate your Monthly Income
- Take your monthly debt payments total and divide it by your monthly income.
- Multiply by 100, the answer is your Debt to Income percentage
A DTI below 20% is considered very good, as you are utilizing only N20 out of every N100 earned to cover debt payments. As you DTI rises, you are considered more risky as your have less income flexibility
Be clear what you want, Lower Cost or Lower Repayments: A 6 year loan is always better than a 4 year loan in terms of cash repayment. This is because the longer the term for a loan, the lower cash repayments, even though loan costs borrower more because you make more payments in 6 than 4 years. However, a 4 year loan will have a lower interest cost that a 6 year loan.
Understand the loan; Fixed or Variable: Also ask if the interest rate charged is fixed or variable; i.e. will the rate rise if he Central Bank of Nigeriaincreases the Minimum Rediscount Rate MPR? Is the rate offered promotional? will it increase during life of loan? How will management fees be calculated?
How can you save money on loan? Ask about early repayments; are there penalties if you pay down early? Also ask for a schedule showing your actual principal and interest payments clearly separated, and any management fees you will be charged. How are your loan payments applied? To principal or interest? Be very clear on this.
Borrow for only income generating activities: If you are borrowing for a business, then only borrow to fund income generating assets. Do not borrow to buy the CEOs “status car”. You can, however, borrow to buy the delivery van. You buy the CEO’s car from profits the business generates…
Match Loan duration to Income: Do not borrow short term via overdraft to fund a long term project such as building a new head office. Be careful about borrowing a term loan with a fixed repayment schedule to fund a contract with the State Government where you are not sure of exact date you will be paid.
Have a payback plan B: If you want to get a mortgage for N5m and the source of repayment is your salary, how is this right? What if you lose your job? How will the loan be serviced?
Keep in in mind this simple equation: At 25% interest rate, if you borrow N100 from the bank, you will pay them back N100 in interest alone after four years. A loan from a bank caries an interest cost and is very expensive, this must be a last option. For startups, remember there are several financing sources to go before you get to loan, including grants and/or angel investor.
Last note, if you own a business, only borrow in name of the Business in order to limit your liability.