One thing that keeps many people up at night is debt. Debt is a major cause of stress, but not all debt should keep you up at night worrying. In fact, some forms of debt should let you dream of a more financially secure future. All debts are not the same; there are good debts and bad ones. If a debt increases your net worth or has future value, it’s good debt. If it doesn’t do that and you don’t have cash to pay for it, it’s bad debt.The next question is then, how do you know you have too much debt? To find out, an accepted formula is your debt-to-income ratio.Add up all your monthly debt payments and divide them by your monthly gross income to get your debt-to-income ratio. For instance, if you have a ETB 15,000 monthly mortgage, ETB 2,000 car payment and pay ETB 3.000 a month for other bills, your monthly debt is ETB 20,000.If your gross monthly income is ETB 40,000, it means your debt-to-income ratio is 50%. It also means you should be losing sleep. Anything over a 43% debt-to-income ratio is a red flag to potential lenders. Evidence suggests that borrowers with a higher ratio are more likely to have problems making monthly payments. In most cases, you can’t get a mortgage if your ratio is over 43 percent.That’s bad, because mortgages are probably the best form of debt!Good debt allows you to manage your finances more effectively, to leverage your wealth, to buy things you need and to handle unforeseen emergencies.Examples of good debt are taking out a mortgage, buying things that save you time and money, buying essential items, investing in yourself by borrowing for more education or to consolidate debt. Each may put you in a hole initially, but you’ll be better off in the long run for having borrowed the money.There is probably no better debt than a mortgage. For one thing, you must live somewhere. For another, you might as well live somewhere that gains value every year.
If for example you buy a home for ETB 2,350,000 and it appreciates 3% a year, it will be worth ETB 4,850,000 when your 30-year mortgage is paid off. If it appreciates 4% a year, that initial ETB 2,350,000 investment will be worth ETB 6,490,000.Now that’s good debt to have.These are basically offshoots of a mortgage. You get a loan using at a relatively low interest rate using your house as collateral.
A lot of consumers use that to pay off other higher-interest debts, while some use it to make home improvements like solar panels that could save money on utility bills and increase the value of your home.The only stress comes from the prospect of having your house foreclosed if you can’t make the payments.
Now, your chances to become financially well off are much better if you start your own company and work for yourself. Small business loans are tougher to get because they are riskier to the lender.
Almost one-third of small businesses fail to survive their first two years, but if you have enough ambition, savvy and luck, borrowing money to start your own business could be the best investment you’ll ever make.
Anything that decreases in value the minute after you buy it is bad debt. Unfortunately, that describes many of life’s necessities, like clothes, automobiles and the flat screen TV you need to watch the Champions League.If you can’t pay cash for them, you should at least consider settling for off-brand clothes and 43-inch TV. Here are examples of bad debt.
While in Ethiopia we are only using debit cards, in many other countries, credit cards are used commonly. Credit cards can ruin your financial health, and interest rates are the silent killer. Figuring them out is confusing, and that’s fine with credit card companies. In the USA, the average household with credit card debt has a balance of $16,784, according to a 2016 NerdWallet survey. That indicates a lot of people are way over the recommended 30% credit utilization ratio.
Car loans are generally considered bad debt. On the other hand, if the interest of the loan is relatively low and you need a car to get to work, you may consider going for it. The most financially prudent move is to avoid a Mercedes when a Hyundai will do. If you want to eventually can afford that expensive car, you will need your dents to be good debts.
Remember, many small holes can sink a big ship!
Source: Bill Fay, Debt.org