How to avoid the bad debt trap

Debt can be very seductive. It offers instant gratification. Why wait when you can have it now? I received a lot of responses from my last article ‘Must you borrow that money?’ and most people wanted to know if borrowing to buy land, build your house, or borrow for your business is bad debt. No matter how noble or emotionally gratifying the expenditure, if the item does not repay the loan, it is bad debt.

You may be able to pull off the stunt, but you need to be aware that you are putting yourself in an exposed position. Bad debts in bank books are held by people with good intentions whose plans backfired. Taking a loan is the easy part, especially through money lenders or friends. Paying back is another ball game. To every undertaking, there is an upside and a downside. You need to plan for both.

Starting with the issue of land or your own house, building your own house is an intensely emotional issue. Owning your own house can be seen as a coming of age as a man. Many have fallen into this trap and ended up with an uncompleted building that can be seen all around towns and villages. Starting a project is not the issue. Finishing is where the benefit is derived. Many parents of ours made this mistake. They sunk their life savings into a never-ending project and retired or died without completing it.

In many instances, the children had to build the place up to make it ‘befitting’ for a burial.

You need to know what you are doing

There are no wrong or right answers. What is important is being aware of what you are doing, so that if things go wrong, you will be prepared and not taken by surprise. Many are genuinely surprised when the road they are traveling on ends in a destination they did not expect. When you accumulate bad debts, you need to be aware of what you are doing. A criminal knows what he is doing, so seeing a Policeman pressing his doorbell does not really come as a shock. He already has an escape plan.

Almost everybody that borrows assumes he can pay it back. Few borrow with no intent to pay back. The inability to pay back is based on inaccurate assumptions at the point of borrowing. Everything looks rosy and seems to add up when you are seeking to borrow. People hate going to banks to borrow because of the rigor of the process. Our half-baked plans hardly stand professional scrutiny. That is why we love money lenders, friends, family, and fools. They hardly ask any questions.

In cash flow terms, your house is not an asset. It does not put money in your pocket. If you lose your source of primary income, your house will not put food on the table or pay your bills. It is important to own your own home, but not at the expense of your financial security. There are folks that are living in their house but have severe cash flow challenges. They have no assets to support their current standard of living. Buying a home on a mortgage makes financial sense since you are paying towards ownership rather than perpetually paying rent to a landlord for an apartment that will never be yours. Again, you need to be sure you can afford the monthly mortgage payments.

If you earn a very good salary, you can choose to borrow to build rather than take money from your reserves. In this case, you can afford the monthly payments, and if all fails, you can borrow from your reserves to offset the loan.

Again, many people believe that investing in real estate is a guaranteed win. You can lose money in real estate if you enter at the wrong time. Real estate prices depend on demand and supply as with everything else. If you put your property on the market and there are no buyers, you are forced to accept the highest offer if you must sell. We are in such a scenario right now. There are many properties with weather-beaten ‘For Sale’ signs that have been there since last year. With the crash in oil prices, dwindling revenues, and a government that may likely be prudent with money, there may not be enough cash to throw about as before. You may find yourself repaying a loan for an item that is losing value in your hands.

As I stated in ‘Should you borrow that money?’, borrowing for business, should be for a tested idea. Ideally, you should borrow to fund expansion. In this case, your existing facilities or arrangement can no longer cope with the increased demand. Borrowing to fund an untested idea is almost like gambling, hence banks don’t like dabbling in it. It is not a wise use of your money, not to talk of borrowed funds. Whatever your business idea, if you don’t have deep pockets, it is wiser to develop and test a prototype first before pumping in money. Be humble enough to start small, make it work, and then gradually scale up. It is known as the ‘Law of Gradual Growth’.

Practice delayed gratification

If we are to be totally honest with ourselves, the reason we borrow most of the time is because of our inability to delay gratification. We are not ready to discipline ourselves to wait for the right time, we want it now. We are in a hurry. We end up putting ourselves under unnecessary pressure. We behave as if something bad will happen if we wait. A little patience can spare us a world of heartache, stress, and acrimony. The heavens will not fall if we say NO.

Debt is a double-edged sword and has to be wielded with skill and utmost care. It can work for you and against you. When in doubt, let it pass. The important thing is to invest in your financial education and acquire financial literacy. Work on yourself. Have clear goals and be prudent with your resources. Don’t try to impress anybody. Just be yourself. Nobody can force you to do what you don’t want to do. This is a democracy.

If you are trapped in a bad debt scenario, stop further borrowing and draw up a plan to pay up your debts. It may involve cutting your expenses, selling off some liabilities, and rescheduling your debts. You may need to see a financial adviser to help you with the process. Don’t look for an easy way out. Face it squarely. It is scary but it will not kill you. You will come out wiser and hopefully learn your lessons.