Weekend Money: Smart and foolish loans

New Zealanders are sinking deeper into debt living in a never-ending cycle of borrowing.

By MARY HOLM

Annual income sterling 20, annual expenditure sterling 19.96, result happiness. Annual income sterling 20, annual expenditure sterling 20.06, result misery.

New Zealanders, apparently, disagree with Charles Dickens' Mr Micawber. For us, happiness is spending more than we earn. Not enough money to buy what we want? Just borrow it.

Figures show that in the two years ending last March, New Zealand households were "net dis-savers" meaning total spending exceeded incomes.

And the latest statistics show that household borrowing, which has soared through the 90s, is continuing to grow at a steady pace.

The Reserve Bank has just raised its benchmark interest rate. Banks are expected to follow suit, raising the rates they pay depositors and charge borrowers.

Will that curb our urge to borrow? Should it?

Sometimes it makes good sense to get a loan. Many a fortune has been built on borrowing. But sometimes it is financially foolish. And, now that inflation is low, foolish borrowing is much more common.

SMART BORROWING

Borrowing is a good move if you do something with the borrowed money that raises your income or your wealth enough to more than cover the interest and other costs of the borrowing.

If you go into an investment the increased income might be coming in at the same time as you are making the interest payments.

If you are borrowing to study, or smarten up a house to sell it for more or to start or grow a business, the increased income will probably come later.

That can be okay, as long as you can either meet the interest payments in the meantime or add the interest to the loan.

But remember that a dollar today is worth more than a dollar next year, and much more than a dollar in 10 years.

To make the whole thing worthwhile, you will need to bring in a lot more later than you are paying out now.

The tough part is that you don't know, at the start, how much more money you will make if you get a degree, upgrade your house or build your business.

And any investment that will bring in enough income and/or capital gains to more than cover the costs of borrowing will be risky.

You will be less certain about the money coming in than what is going out. You must be sure you have enough cashflow to make debt repayments.

In these times of low inflation you cannot rely as much as you could in the 70s or 80s on the value of a property or other investment growing fast, while the value of the debt repayment dwindles.

There will always be a chance - in some cases quite a large one - that you will be worse off for having borrowed.

This can happen particularly when gearing goes wrong.

The most common example of gearing is when you buy a house with a mortgage.

Let's say the house costs $100,000, and you pay $20,000 and get a mortgage of $80,000. (Make it an interest-only mortgage, to keep the example simple.)

If you later sell the house for $140,000, you pay back the $80,000 loan and keep $60,000. You have tripled the money you put in.

If instead, you had paid the full $100,000, you would have made $40,000 - a much lower return.

Of course in the geared investment you had to pay mortgage interest. But your big capital gain more than makes up for that.

Gearing makes a good capital gain into an excellent one. But it can also exaggerate a loss.

If in our mortgaged example you had to sell the house for $90,000, you would be left with $10,000 after you had paid back the loan. You have halved your money - and paid interest to boot.

But if you had paid the $100,000 with no mortgage, you would have lost just 10 per cent.

When inflation was high, it was rare to sell a house for less than you paid for it. People gained in a big way from gearing.

These days, though, house prices do fall sometimes.

Some people gear up their investments in shares or a share fund with the same results.

Gearing raises risk. With that comes a higher potential reward, and also a bigger chance of things going wrong.

That does not mean you should not borrow to invest, or for education, business growth and so on. It can still be the key to wealth.

But before you take a loan be pessimistic in your forecasting and consider how you would cope if things do not work out as planned.

FOOLISH BORROWING

Clearly, any of the borrowing mentioned above that goes wrong could be called foolish.

More foolish, though, is borrowing to buy anything that brings in no income, decreases in value or has no lasting monetary value.

Furniture, appliances, clothes, travel and entertainment fall into this category.

Cars often do as well, although you might need a car for work. In that case, borrowing to buy as cheap a car as possible makes sense.

Many New Zealanders routinely buy larger items with credit cards, on hire purchase or some other high-interest time-payment arrangement.

They pay them off over many months and in the process sometimes pay as much in interest as the item cost, or even more.

Over a lifetime, this interest can amount to many thousands of dollars.

If, instead of doing that, you make a practice of saving for items before buying them, you will earn interest instead of paying it. Also, you can often negotiate a cheaper price if you are paying cash.

What to do if you have made some foolish borrowing?

Pay it back as fast as possible, perhaps by automatic payments out of a bank account. Start with the loans carrying the highest interest and work your way down.

Getting rid of debt - especially non-productive debt - is one of the best financial moves anyone can make.