The principle of owing money is commonly based on the fundamental exchange of a commodity for credit. In ancient Greek history, this meant the exchange of precious metals, such as gold for money. Nowadays, debt is used in so many different aspects of life but few people really understand the concept behind it.
While the Philippines’ household debt growth has far exceeded income growth in recent years, debt growth is coming from a very low base – the country’s total household debt is by far the lowest in Asia.
More than 90 percent of total Philippine’ debt lies in the corporate and government sectors. Private sectors have ample room to increase leverage to boost consumption and sustain growth. However, in order for debt to be a successful component of private sector growth, there needs to be much more education about what debt really is and how it can be used to our personal advantage.
To most Filipinos, all personal debt is bad. It’s money you owe, and that’s never something we look forward to. But things are more complicated in reality and not all debts are equal. After all, there is a reason why even wealthy people take loans for their houses or cars when they can pay everything in full.
Good debt. Without overcomplicating things, consider this: you borrow P2 million to buy a house valued at P2.5 million. With a 10-year loan tenure, at an interest rate of about 5 percent, monthly amortization payments are about P21,000. While for many this might sound like a frightening burden to take on, a savvy property investor does not look at the monthly repayment but rather at the rental income it can yield, or the underlying asset value. The savvy investor realizes that the property is located in a neighborhood that is in high demand, and rents for similar houses are usually around P30,000 per month. Without even considering the value of the house itself, the investor gains P9,000 each month.
After 10 years, the savvy investor sells the property for $4 million, because demand has gone through the roof and the property’s value has appreciated. The difference between the buying price yields a profit of around P1.5 million. On top of that, 10 years of rental income (assuming no vacancies) would have yielded P1.08 million. Where less savvy investors saw a P2 million debt, the smart investor saw more than P2.5 million for the taking.
A good debt is an investment with returns that exceed the debt and its repayments. While the above example is simplified, it often helps to go back to the basics and understand loan terms before entering into an agreement. Not all debts provide the same returns and should be carefully evaluated and deemed appropriate for the intended purpose.
Other examples often referred to as “good debts” are education loans and business loans. While a degree may be expensive, it can provide opportunities that will repay the education loan many times over. Business loans are more expensive than home loans or education loans because the lender, the bank in most cases, wants to be rewarded for the high risk of the business failing. Note, however, that the returns can also be extremely high if a small loan is all a young entrepreneur needs to start a successful new business.
Bad Debt. Bad debt offers no possibility of raising your net worth. The money used to repay bad debts is simply lost. The best example for this is credit card debt to buy a new phone. Unless you use the phone in a viable commercial manner, there is no chance for you to resell it at a profit. The same principle applies to all things that do not directly generate income for you. Hence, avoid incurring bad debt for luxuries, such as taking big loans to go on vacation, or buying the most expensive car for which you can take a loan.
Other loans that would fall under a similar category are payday loans. It may be relatively easy to borrow money from payday loan companies, but it’s very difficult to pay them back. These companies loan out money with terrifyingly high interest rates, taking advantage of the fact that many people are desperate for cash and do not have enough collateral to avail of a bank loan.
Sometimes we have no choice but to acquire bad debt if we need a loan for medical reasons or if you face litigation. Instead of using a cash advance from a credit card, find a personal loan with lower interest rates and a manageable instalment plan.
Modern life often requires us to borrow money. Knowing the difference between good debt and bad debt and even more importantly, understanding the concept of debt, can make a big financial impact on your financial health and chance of a successful investment. Do not be scared of debt but use it as a tool when seeking to improve your life or your financial situation.
Moritz Gastl is the Managing Director of MoneyMax.ph, a financial comparison website aiming to help Filipinos save money through diligent comparisons of financial products.