Debt can be a good tool or a nightmare depending on how you use it. Debt is good when you use it to acquire an asset or investment which generates sufficient cash flow to pay off the loan.
Debt becomes a problem when you’re unable to pay it off. This problem can happen if you borrow too much or the business venture doesn’t perform as expected.
Debt often increases the risk and cost of a transaction. When you take out a mortgage on your family home, you carry the risk of foreclosure until you pay off the loan. You also pay much more than what the house actually costs.
We can evaluate the risk of debt by looking at four metrics. The first is the proportion of debt to our net assets. The higher this metric, the higher the risk you are taking on. Generally, you want this ratio to be less than fifty percent.
The second metric is the proportion of monthly payments to your income. You don’t want to exceed forty percent of your salary or earnings in debt repayments. If you do, you might struggle to meet your day-to-day expenses.
The third metric is the cost of the loan. The most obvious is the interest cost which depends on the interest rates. Some rates are fixed by the lender, while others vary with the economy. Fixed rates are advantageous when the economy worsens but are terrible if the general market rates go down. The opposite is true for variable rates. It would help if you also looked at other costs like insurance, arrangement fees, early and late repayment fees, etc. There is also an opportunity cost for any collateral offered in securing the loan. The prospective borrower should watch out for exorbitant rates which exceed the benchmark rates set by the central bank.
The final metric is the duration of the loan. The longer the loan, the higher the total interest you will pay. It is best to match the length of the loan to the duration of the investment. The borrower should use long-term financing for long-life assets and short-term borrowings for short-term projects. The prospective borrower should limit the duration of the loan to a reasonable period.
Your income is the greatest tool you have to build wealth. Debt encumbers your income from building assets and investments. If at all possible, try to avoid debt as much as you can. If you do, you will live a happy and stress-free life!