Posted by Robert on August 15, 2011
Some commentators on personal finance like to repeat that there’s good debt and bad debt. They talk as though the nature of the debt itself changes, which is nonsense. Debt is debt, and adding good debt or bad debt to a decisions doesn’t make it a good decision or a bad decision. Debt is a magnifier, used to leverage resources. Debt will magnify the outcomes of good decisions and bad decisions equally.
If the outcome of a decision progressed in a straight line (eg. getting consistently better and better or worse and worse), it would be simple to act in ways that produce good outcomes. But that’s not normally the case, and our fortunes often bounce around, going from better to worse and back. When debt is used to magnify the outcomes, this cycle might produce ruin in an storm that otherwise could be waited out.
As an example, let’s consider a person who buys a car. They have a steady job with a healthy paycheque, but they have no savings. They are faced with two choices: save for the car from each paycheque or buy a car using a loan. Suppose they choose to save $500 per month for a year, or they can get a bank loan that will charge $500 + $25 interest per month for a year. The interest cost makes the loan a less efficient choice, but the car can be enjoyed now, not one year in the future. The problem comes if the employer has a problem with their salary payments and is a week late with a single paycheque. In the “saving” scenario, the employee can dip into their savings, postpone a deposit to the car account, and continue successfully. In the “loan” scenario, a single missed payment might cause the bank to repossess the car, causing the money already paid to be lost.
The risk of borrowed money exists regardless of the purpose of the loan. Whenever a loan is arranged, the risk of default should be protected against by having the ability to make payments (or complete repayment) if other sources of income fail. If a person is satisfied that they are suitably protected against the risks of a loan, they can decide whether or not the purpose of the loan justifies the cost.
The problem, it always seems like a good idea at the time (or no one would ever take on debt). I don’t think it’s always easy to identify good debt, however. I recommend starting from the assumption that debt is always bad. From there, debt may be acceptable if it is an investment in producing future income in excess of the interest cost. As an example, buying a business using debt could make sense. The income from the business should pay the investor’s salary, the interest on the debt and a little profit. Buying a car could be good debt, if it makes it possible to get a job with a generous salary. Buying a more expensive car than necessary mixes bad debt with good debt. Buying a house isn’t really good debt except that it avoids losing money by paying rent; it still doesn’t make sense to buy more house than necessary.
When do you think student loans good or bad debt? Have you had other debt that you consider “good” or “bad”?
This post is now part of the #323 Carnival of Personal Finance.
Posted by Canadian Dream on August 10, 2011
As this latest slide in the markets I keep reminding myself of what happened in 2008. I got nervous and I was really pushing the limits of my comfort zone with the losses in my equity part of my portfolio. Yet I still recall the one real benefit of 2008: I bought all the way down and made a nice profit in 2009 from it.
So this time around I significantly more at ease with the entire ‘panic selloff’ that recently occured. I ask myself the following questions:
- Has the fundamentals of any of the companies I own changed that much from last week? No.
- Has the debt downgrade of the US really going to gut all growth around the world for the next decade? Likely not.
- Is the market then likely reacting more out of emotion rather than real issues? Almost certainty.
So I have changed my plans a little bit for this year. It was looking like I might exceed my mortgage goal by a bit, but I decided to instead leverage the amount of money and borrow some money from my line of credit to invest. So I’m just waiting to finish moving $5000 over to our TFSA accounts and pick up some more shares of companies that we already own. Yes I know this means I can’t write off the interest as a tax expense. I’m ok with that as I can easily make more than the 4% that I can borrow the money at.
While I’m not ignoring the risks to the global economy, I do think people are significantly over reacting. Yes there is debt issues with many countries and I do expect a lot of volatility over the next few years from it. So while this sucks to live through you should consider the fact that drops like this might get a bit more common over the next decade.
Perhaps the only advice I have for anyone who is near retirement is…don’t keep so much in equities if you are now thinking about pushing off your retirement now. I keep saying it, but perhaps it will sink in this time. You don’t need 50% or more of equities when you are within five years of retirement. In fact you should consider keeping the number closer to 25%. I know it goes again the advice of a lot of people, but I keep saying people grossly over estimate what they need for returns and keep way to much risk of losing their capital when entering retirement when you have no means of replacing it.
So how have you handled the last week or so on the markets?
Posted by Dave on August 9, 2011
Have you ever noticed that people who have no financial plan tend to be surprised when disaster hits? For example, their two-vehicle household has two vehicles break down on the same day, at the same time their air conditioner breaks down. Now admittedly, this is just terrible luck, but it’s weeks/months like these that put people into a debt-spiral that takes some time and dedication to get out of.
In contrast, I assume that at some point all of this stuff will happen to me, and possibly all at the same time. This may be seen as a very pessimistic way of looking at the world, but realistically my main goal is to ensure that I do not experience a financial “hit” that puts me into poor financial shape. Beyond putting the brakes on my goal of early retirement or financial independence, such an event would be very stressful for my wife and I (or anyone) to take on, which for the most part with adequate planning can be totally avoided.
Here are some techniques my wife and I employ for avoiding financial disaster:
1) We keep our monthly expenses low: In doing so, such things as prolonged unemployment or disability (to a certain extent) can be mitigated as our expenses are set up so that the low-earner can cover our total monthly expenses.
2) We have a decent-sized amount of savings: Since we cleaned out entire savings account buying a car in March, this has been our number one goal. Having no savings means that something as small as a car repair would cause us to utilize debt, which we would like to avoid at all costs. Our end goal for savings is to have an entire year’s worth of “fixed” expenses (around $10,000).
The reason for this is two-fold – the first being insurance against unknown expenses, the second is if we don’t really feel like working at our current job / career, there is a buffer we have built into our finances to allow for a job-search or lower wages if the new job doesn’t pay as much.
3) We have a bunch of insurance: Car insurance, life insurance, CAA for automobile breakdowns, as well as health insurance through my workplace which provide a cushion for expenses that if we incurred them at 100% would put significant strain on our finances. I don’t really like to pay for the insurance, but the peace of mind it provides is worth it when I examine what would happen if I didn’t have it in place.
I don’t really think there are many financial disasters that can’t be planned for, I just don’t think many people think about the downside or have the same pessimistic viewpoint as myself or others with a robust financial plan.
How do you plan against financial disaster? Do you think you have a negative viewpoint in thinking up a financial plan?
