All debt is equal? Think again…
ALL debt is the same right? Not exactly.
This is according to Adrian Goslett, Regional Director and CEO of RE/MAX of Southern Africa, who says very often consumers seem to put all debt in the same category, however, while all debt is debt, it is not all equal.
“Identifying the difference between bad debt and what could be considered as potentially good debt will assist consumers to make more informed and better financial decisions moving forward,” says Mr Goslett.
Before the global property market downturn, many homeowners would turn to their home equity as a credit source when they required large sums of money.
However, post-recession thinking is somewhat different, with homeowners rather paying down their home loan accounts as much as possible to ensure that they see a greater return on their investment should they decide to sell.
As a result, a popular alternative would be for consumers to dip into their retirement funds and take portions of this money in cash when needed. Unfortunately, he says taking money out of retirement investments will only cost the consumer in the long run and have a detrimental impact on their retirement income.
Mr Goslett says that instead of getting to the point of resorting to taking away from a retirement fund, it is important to understand the nature of the debt and see whether it will put the consumer in a better or worse positon then they are currently in.
“It is extremely important for a consumer to make the distinction between a good debt, a necessary debt and a bad one, as this will help to drive their decision-making process.”
He says the determining factor between a good and bad debt is that a good debt will result in the consumer’s financial value growing over time.
“A prime example of this is a bond, which results in the consumer owning an asset: a home. The property not only serves the con- sumer’s need for shelter, but also appreciates in value and grows the consumer’s net worth over time,” says Mr Goslett.
“Something to consider however, is that a loan can tip over into becoming a bad debt if the homeowner becomes financially distressed and can no longer afford their property.”
This emphasises the importance of having a financial contingency plan in place when purchasing a home, he says.
A necessary debt would be something that would change the consumer’s station in life, such as a student loan. In order to fund their education, most students will require some kind of loan. While this means that they will start their career in debt, it will also provide them with the opportunity to earn a higher salary or possibly fast-track their career progress, he says.
Another necessary loan for most would be car finance, however, this can also fall into the bad debt category if the buyer selects a car that is far too expensive to run or maintain.
According to Mr Goslett, any debt that is purely for consumption is bad debt, like holidays, food or items of furniture, for example.
“These kinds of items will not retain their value. Taking out a loan to pay for these items is never a good idea, as it will only place more financial pressure on the consumer and put them in a worse off position as they will end up paying off these items for months, or even years, without any financial return,” says Mr Goslett.
He says regardless of what category the debt falls into, ideally the sooner the debt is paid off, the better off the consumer will be.
“The fact is that debt accrues interest and the sooner it is paid off, the less interest a consumer will have to pay. More importantly, once all debt has been paid, a consumer has the freedom to start saving and building a nest egg for themselves,” says Mr Goslett.
Consumers need to make the distinction between a good debt, a necessary debt and a bad one.