It Should Never Be Funded By Debt

Category: Finance, Credit.

It is essential that you get in control of your finances from an early stage- but does that mean not having any debt?

Quite often when I speak to people in debt I find that they didn t know what they should or shouldn t borrow money for. When is it right to take out a new loan? They could benefit from this simple but very powerful rule for their personal finances. Quite often it is the feeling of not being in control that gets people down. It allows them to plan, feel in control and not resent their debts. This nice simple rule has worked for me for years and helps to decide what you can and cannot afford, when it is right to borrow and when it is not.

Accountants talk about things such as" amortisation" and" useful economic lives" . It draws from my economics background and my professional accountancy training- but despite that it s very simple! This means that if you buy an asset such as a building or piece of equipment the cost gets spread over several years- over its" useful economic life" . But what has this got to do with debts and loans? Economists have a different language( you may have noticed! ) and they talk about utility - ie the satisfaction you get from consuming a particular product or service. Well my simple rule comes from both of these concepts combined.

Of course being an economist at heart, I shorten this to the" BJB" rule. The result is what I call the rule of" Benefit- Justified Borrowing" ! So what does it mean? In other words borrowing should only be justified by the benefits that will flow to you in the future from what you have purchased. Quite simply this: only borrow money to fund something that will continue to give you some satisfaction or benefit over the life of the loan that is funding it. Think of it like this- you are buying a reservoir of satisfaction, benefit or enjoyment that will last for several years and this is the reason that you can justify a loan to fund it. A perfect match!

To the economist you are deferring your consumption and you are deferring the funding of it. That s all a bit abstract- so let s look at some examples: Buying a house- it s unlikely that you can pay cash for it- so you have a mortgage. Furniture- let s say that a piece of furniture will last you for 10 years and you fund it by a loan. This fits the BJB rule because you will derive benefit from living in the house over the life of the debt. Again this fits the BJB rule very well. You could choose to have a loan over any period up to 10 years, although in reality you would probably want it to be less than 10 years- as it would be sensible to take into account what the furniture might be worth in the future.

The next question is how long the loan term should be. If it was likely to be worth nothing after 5 years then this would be the sensible maximum term of the loan. Many people go on vacation and thoroughly enjoy it but then have expensive credit card debts for months afterwards. Vacations- this is a great example. This is where the resentment can kick in- you get to a point where you are desperate for the next vacation but can t afford it as you are still paying off the last one! If you follow my BJB rule you will never fund a vacation with debt because when you are paying off the debt you are no longer getting any satisfaction or benefit from the purchase you have made- the vacation is over.

This is depressing- and cancels out the original enjoyment! This is where good old- fashioned discipline comes in- save up first for things that do not have a future benefit. You are going on vacation, knowing that it is all paid for, with cash in your pocket in accordance with the budget you have set. Imagine you have followed the BJB rule. You can go away with a clear conscience to enjoy a relaxing break- and then when you come back there is no debt hanging over you to pay off! You will hopefully realise that this would not meet the BJB rule!

The last example is your usual day to day living costs. It should never be funded by debt. So does this rule mean never use a credit card? If you are building up long term debt to fund your day to day food and living costs then you urgently need to address this issue and should seek some help and advice without delay. Not at all- short- term loans can have their place- but it does mean only use it when you understand how you will pay off the debt. Occasionally it is necessary to use short- term debt such as a credit card to get over temporary and short- term cash- flow difficulties. So like all good rules the BJB rule has this one exception.

Life rarely goes according to plan and you may just be a month away from having completed your savings plan. Using a credit card means that you don t have to have saved up every last penny before packing your cases. A good example is back to the vacation- clearly it would be ridiculous to cancel it because you were short of savings by one month! However using a credit card should be in the context of a solid plan to pay off your debt within a couple of months of your vacation. Clearly this exception to the rule is about a small shift in timing and is quite different from building up medium to long- term debt that is not benefit- justified! You have already mentally spent that money for the next month or two. So from now on follow the" Harper BJB rule" and match the debt to your enjoyment and you shouldn t resent a debt again!

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