Financial Planning (5) Borrowing

So in lesson 4, the James Family came to the conclusion that they have to borrow to afford a home. So this lesson, we will discuss borrowing and debt and how to go about it.
When you borrow you go into debt, technically your liabilities increase. Debt increases cash flow, thus your Gross Income rises, but it also increases the expenses on your Non-Discretionary budget via Interest repayments.
In the Life Style approach in financial planning, it is common that from the early earning years, say age 20 to 40 years, the net income or net discretionary cash flow is low. At this stage debt is often usually used to acquire assets. These are two kinds of debt, there is good debt and bad debt…
Good debt is any debt where the interest rate charged on the borrowed cash is lower than inflation or expected investment return. A Debt is also good where the repayment period is less than the expected life of the asset purchased with the debt. An example of a good debt is a mortgage loan. Eg if the James were to get a 8% loan for 10 years to purchase their home. That would be a good debt because the repayment period of the loan is shorter than the economic life of the asset purchased i.e. the house.
Bad debt is debt where the interest rate charged is high or where the economic life of the asset purchased by the debt is shorter than the debt repayment period. For example paying for a holiday with a credit card. The card has a high interest rate and the holiday has no economic benefit (yes it may have health benefits). Another example will be a consumer loan of say 30% for 5 years to buy an asset like a stove that has an economic life of say 3 years.
In summary
Good debt has a low interest rate, is long tenured and the purpose of the debt has a longer economic life than the debt tenor
Bad debt has a high interest rate, short tenured and the purpose of the debt had a shorter economic life than the debt.
How to use debt responsibly
So how do you borrow responsibly? Well we calculate the cost of the loan and compare to the economic benefit from the loan. The cost of the loan is the interest rate, the economic benefit is measured in how that loan adds to your asset base or net discretionary cash flow. In general, Debt should be used to increase your net income or your assets. Be careful of using debt to purchase assets that depreciate faster than the loan is repaid. The most important thing is to minimize borrowing with an interest element. Thus seek out sources of finance that do not charge any interest eg borrowing from family and cooperative societies. When you have exhausted all sources of non interest borrowing, you can approach a bank for a loan. Now keep in mind the longer you can spread out the loan payments the better for your budget.
  • A 6 year loan is always better than a 4 year loan because you repayments are lower.
  • Also ask your bank if the interest rate charged is fixed or variable i.e. will the rate rise if he CBN increases i.e. Variable. If it’s variable, then your borrowing cost will go up as the Central Bank raises rates.
  • Ask the bank about early repayments, are there penalties if you pay down early?
  • Also ask for a schedule showing your actual principal and interest payments clearly separated, and any management fees you will be charged. Be very clear on this.
  • If you’re borrowing for a business, then only borrow to fund income generating assets. Do not borrow to buy the CEOs “status car”, you can borrow to buy the delivery van. You buy the CEOs car from profits the business generates….
  • Also watch timing, don’t borrow short term via overdraft to fund a long term project eg building a new head office. Be careful about borrowing a term loan with a fixed repayment schedule to fund a contract with the state government where you are not sure of exact date you will be paid.
  • Keep in in mind this simple equation, at 25% interest rate, if you borrow N100 from the bank, you will pay them back N100 in interest alone after four years bank interest loans are very expensive, this must be a last option.
So back to the James Family, they have about N4m deficit to borrow, how they should responsibly borrow. First the ask family and friends, then they consider financial institutions that charge a lower rate of interest eg cooperative unions. Only after this should they approach the bank to borrow. The interest payments to repay the loan will go into their Non-Discretionary budget and will reduce their discretionary cash flow, but should they pay for the house, their Assets will increase to balance out.
It’s important your cash flow can comfortably pay down a loan.
Last point when you borrow its important the interest cost does not completely take away your discretionary cash flow, in other words, keep some cash handy, cash is king.
So we stop here, next week we discuss debt management, i.e. how to get out of debt and then use a new case study to determine how to budget and plan if your income stream is irregular eg a contractor…
Financial Jargon of the week
A Slowdown, a period of slow but not negative economic growth…
A Recession; a recession is two consecutive quarters of negative economic growth as measured by the GDP…
A Depression is a depression is commonly defined as an extreme Recession that lasts two or more years
Question of the Week
Is Esusu aka Ajo, the group saving and borrowing really a good idea?