Is your debt working for you?

When banks lend us money, the debt is categorised into either performing or non-performing loans.

If you took a loan from the bank and were making your loan repayments every month on time, yours would be classified as a performing loan. However, if you did not service your monthly loan repayments, your loan (in the bank’s books) would be classified as a non-performing loan.

Because you are not servicing your loan, the bank is not earning any income from it hence it is a bad debt. It is not money that is working for the bank as long as the loan is not being serviced.

Similarly, we have non-performing loans or bad debts in our lives. Any debt that is not working for you is in essence a bad debt. Let’s say you take a loan to buy some property.

Over time that property appreciates in value and maybe you are even getting income in the form of rent. That is a debt that has worked for you because your returns (through appreciation and income) have exceeded the cost of the loan i.e. what the bank charged you in interest. Maybe you borrowed Sh500,000 and over five years paid another Sh300,000 in interest.

GOOD LOANS

The total cost of the loan is Sh800,000. If at the end of the five years you can sell this property for Sh1.2 million, that is debt that has worked. You have made Sh400,000 by using someone else’s money. It’s a win for the bank because they got interest out of you and it is a win for you because you made a profit of Sh400,000.

Worst case scenario: if the bank demanded their money back at any point during the term of this loan, you can sell the property, pay back the bank and retain any profit.

Then there’s the other side of the coin when it comes to debt. Say you took the same Sh500,000 to buy furniture for your house. Over the same five years your furniture will be worth Sh300,000 yet you will have paid the bank Sh800,000. You will have incurred a loss of Sh500,000 even if by chance you were able to sell the furniture.

This loan has not worked for you and is what you should consider a bad debt. If the bank demanded their money back, most probably you would have to look for funds elsewhere to top up the deficit between the value of the furniture and what you owe them.

This is because you took a loan for something that decreases in value. This type of loan puts you in a worse off financial situation than before. Unfortunately this is the debt that many of us are taking on when we buy TVs, phones, entertainment, shop with credit cards and even pay for holidays. This is the debt that we have to work very hard to get out of. This is the same kind of debt that many people are burdened with.

SKEWED VIEW

This debt creeps up on us very slowly usually one item at a time. The problem with this kind of loan is that it starts to teach us to borrow for things as opposed to saving for things. The minute you start borrowing for a phone, you will obviously borrow for the TV, fridge, holiday, etc. Delayed gratification is thrown out of the window.

We get into problems because we start to view our ability to afford things based on the monthly repayment rather than the overall cost. You don’t look at the decision to borrow to furnish your house as a cost of Sh500,000. Rather you look at it as Sh12,000 per month.

In a matter of time majority of your income is spent servicing a series of monthly repayments on various items and you feel you cannot breathe. If you are not already in this cycle, do not get into it. Live within your means and rather than borrow, challenge yourself to find ways of creating income.

Teaching yourself how to create an extra Sh10,000 per month is much more powerful than teaching yourself how to repay a consumption loan of Sh10,000 per month. If you are already in this cycle do not take on any more bad debt. The answer is never in yet another loan although we sometimes feel that will temporarily ease the pain. If the last loan did not prove to be the answer neither will this next one.

Many people have asked me how to get out of this kind of debt. No one can get out of debt for you. You have to make that decision for yourself.

The decision entails getting out of a comfort zone because as much as you are struggling, the answer to this lies in finding extra money to be able to at least service and, better still, pay down debt faster. How rich would you become if all that money you were using to service debt went into investments?

NO MAGIC PILL

Just calculate in a year how much you are paying for your bad debts. From the many discussions I have had with people on this topic, most seem to want to live in exactly the same way and at the same time miraculously get out of debt. It just cannot happen.

You cannot go out for lunch everyday and expect to be given a magic pill to get out of debt. You may have to carry packed lunch and use the money saved to pay down your debt. You may have to sell some of that furniture. You may have to give up on entertainment and driving your car for a while.

Rather than sleeping in on Saturday morning is there something you can do to generate some income? There is a specific action you have to take. Get rid of your bad debts as soon as possible and get all this money you are paying the bank to start working for you.

Waceke runs a program on personal financial management. Find her at [email protected]| twitter @centonomy