Debt – Friend or Foe?

Is debt your friend or foe?

In the Part 1 of this series, an Overview of debt and borrowing, we looked at the different types of  borrowing facilities that can be accessed by the three main groups, Government, companies and private individuals. In this article, we will concentrate only on those that are available to individuals and families.

We will look at both sides of the coin by considering the benefits that most people gain through borrowing and how it can improve their quality of life but also look at downside of borrowing and when to realise things are going wrong. In extreme cases, when to accept that you are out of your depth and need to seek help.

The search for wealth

Most people dream of being millionaires and think that having vast amounts of money would be the solution to all of life’s downsides. However, their is a view that the road to financial happiness does not depend on how much you have accumulated but is more to do with whether you have enough money to comfortably fund your realistically desired lifestyle.  Achievement of wealth can be defined meeting three yardsticks as explained below:

• Income Rich – this yardstick would be met when your income is more than all of your accumulated outgoings, leaving a reasonable margin for saving.
• Property Rich – This yardstick is usually met over time as the equity gained in property is normally acquired over many years, 25 years being a typical time frame. However, when all outstanding loans on your property have been cleared, or have been very substantially cleared, you can consider this yardstick to have been achieved.
• Cash Rich – this would be met when you have accumulated sufficient capital, either cash or invested capital which is not earmarked for any specific purpose but simply provides financial security for you and your family.

The happy financial journey through life

A happy financial journey through life for young people and young couples with family, who are starting at the bottom, would begin when they achieve a balanced position with their finances on the journey to achieving first criteria and then improving as they achieve a surplus.

However, many young people do start out with decent job prospects and soon reach the ‘income rich’ state.  This provides them with the means to support borrowing in areas such as mortgages, car purchases, holidays and social lifestyle.

Starting the property rich state through purchasing your first home is often the next goal and will usually result by around the mid life point in having achieved, or be close to achieving, the property rich stage.

At the mid life point, any children will be beginning to think about leaving home or be contributing to the household costs. Outgoings on mortgages should be reducing, at least as a portion of income, which in turn can provide the means to allow savings and investments to be created.

As retirement approaches and hopefully having achieved the three financial yardsticks, it can generally be expected that a happy and stress free retirement will be foreseen with he knowledge that your financial prudence over your lifetime will enable you to leave a nice inheritance for your children, when the time comes.

A Typical Example

Take a walk through any newly built housing estate and you will no doubt find plenty of examples of young couples who have bought a house with a mortgage loan, have newish high end cars sitting in the driveway, take regular overseas holidays and have their immaculate home furnished with the latest in designer fashion.

Typically, such couples will have high levels of income which is only balancing their outgoings, much of which is going to pay off the debt they have accumulated on these possessions and lifestyle pursuits.

Such couples have made a good start on life’s journey and providing their income remains secure and they never overextend themselves, they should be well on their way to achieving financial happiness throughout their lives.

When borrowing and Debt can be your Friend

As the above example shows, without access to borrowing, that young couple would not have been able to surround themselves with such items, even with their high income position.

This equally applies to people on very low incomes as most goods, including clothes and other very low cost items, can be bought on credit. Often, people on low incomes can only manage to keep their heads above water through borrowing.

It is therefore reasonable to conclude that provided that borrowing is kept at affordable levels as dictated by income and any special demands on your funds, a better standard of living can be obtained where you can enjoy today, many of the things that can improve your lifestyle

How borrowing and Debt can become your foe

Using the the same typical example but from the position where things go wrong, we begin to see how quickly a great situation and happy outlook can change into a world stress and unhappiness.  We show below a few examples of some of the things that could cause such change  and bring about a situation where the accumulation of debt can become a seemingly insurmountable problem to resolve.

• Relationship breakdown – When the couple decide to go their separate ways, the effects of financial arrangements and child care settlements through the courts could cause one or both of the partners to be unable to support the burden of payments on their various loans. Should any repayments on loans go into default, the lender may lodge this with the credit agencies, which may in turn might affect your future ability to borrow. Mortgages and other loans could become extremely difficult to obtain. This could put you ambitions on hold for some time to come.
• Serious illness – young people tend to think that they will live forever but in reality, many young people do become seriously ill or suffer severe disability. Where this results in the loss of a good career and where no provision has been made to insure for such an eventuality, then the loss of income could put similar strains on the family finances as described in case of ‘Relationship breakdown’ above.
• Rising bank interest rates – Interest rates are currently at very low levels and this tends to encourage people to borrow larger and larger amounts. However, in the balanced income to outgoing scenario in the example, an interest rates  rise could cause that balanced position to become negative. Back in the early 1980, interest rates stood at around 16%. Imagine if that situation  were to return, the shortfall could become quite substantial.
• Mortgage fixed term rate expires – most mortgages that are taken out have a fixed rate period, usually from 2 to 5 years. At the end of that period the lender will move the mortgage to their higher variable rate, unless you remortgage to another fixed rate.  However, if the couple in the examples credit score were reduced or, if the property valuation went down, the lender probably would probably not remortgage on the same good terms. Again, this could cause the balanced position, we discussed earlier, to become negative.

Conclusion

In view of above as you can see there are many ways for borrowing to go wrong and this will always be the case unless the three yardsticks mentioned at the beginning of this article have been met. We can never be sure of what lies ahead but if we borrow sensibly, well within our borrowing capacity then we stand a good chance of overcoming any problems that unexpectedly arise.