Part II: When borrowing is wise and when it is not
We have established what a loan is, and that it should be paid back with borrower and lender both winning in the transaction. Now, let us take a look at the different types of loans. Understanding these will help us avoid debt that might cause us problems.
I am categorizing the different type of loans according to whether or not they should be avoided. If you now have a loan that belongs to the category that must be avoided, please don’t despair. There is always hope.
I am saying that there are loans that should be avoided for the sake of those who haven’t taken a loan yet. The emphasis should be on improving management so the necessity of a loan to patch up cash flow deficiencies caused by poor management can be avoided. Many people use credit card debt to ease their cash flow and pay installment interest rate of 3.5%p.a. That is very high. A better way is to control expenses and pay the loan quickly so that interest expenses stop.
As we have said before, the issue is management and not debt. So, we can categorize debt into 2 classes, those that provide additional tools to enhance good management (qualified borrower) and those loans that hide our poor management (not qualified).
1. Loan Obtained to Enhance Good Management
To give an example, several years ago we bought a house by taking a 10-year loan from a bank to partly pay for it. The rest of our payment came from sale of a small property and some savings. We prayed about this because it was our biggest investment then. We paid each monthly amortization and to do that, my wife and I had to make many sacrifices. After 7 years, somebody knocked on our door, offering to buy the property for 7 times my purchase value. We sold it, and used 70% of the proceeds to buy another house without taking a loan. So today, we are debt free on a house we own. Today, after 30 years, the value of my present house is 40 times the value of the first house I bought. If I did not take a loan, I could not have arrived at the same result. I will most probably be still living in an apartment. I used the loan for something that increased in value. My earnings paid for the loan.
How about cars? They don’t increase in value. But I need it to effectively perform in my business and earn income. Therefore, I can consider it as an earning asset and borrow for it for as long as my income can afford it.
The same thing can be applied to business. We should ask ourselves if the loan will be used to buy an appreciating or earning asset and whether or not earnings will match the payment or amortization required by the lender.
2. Loan Used to Cover the Result of Poor Management
Here is one case. The borrower does not know how he will repay the loan, and he is in such dire state that he needs more money to keep on going. So he borrows more to hide his deficiency. This is like a ticking time bomb.
Or the borrower is mismanaging his business but does not know it. Soon, cash flow becomes tight and still he has no clue about his poor management. To alleviate the situation, he borrows, which further aggravates the problem because now he has to pay interest which is an additional cost. Soon, he finds out that he is in a sinkhole. He didn’t bother to evaluate his management. Maybe there is pilferage. Maybe there is overstocking. Maybe there are collectibles that are not being collected and yet he keeps on selling to the same customer. Or maybe he mixed his business with his household finance and he did not realize his luxurious travel expenses have eaten up into his working capital.
Or the borrower is not actually in a bad situation but borrows too much without carefully evaluating how he is going to repay. In this case, the borrower might soon find out that he is in a bad situation because of the loan he took. This may be as simple as credit card debt or a loan used to buy asset whether for business or personal use. As I mentioned earlier, additional money from other people (OPM) must result to multiplication in value, without which, the borrower will not have the means to pay.
We can therefore conclude that debt is a tool. Like any other tool, the user must know how to use it. Placed in the hands of the good manager, he can create value that will benefit both borrower and lender. Placed in the hands of somebody who don’t know how to use it, debt can do harm.
Other things you have to consider when borrowing are the following. How long should the term of the loan be? This will depend on the type of asset and your capacity to pay.
For example, lenders don’t lend for more than 5 years for cars because of the perceived life of the asset. However, they can grant term of more than 10 years for loans intended for house purchase. Loans for short term use like business loans for raw materials or receivable financing are short term loans. Is the term of the loan matched with your capacity to pay?