Jill Kerby

GOOD DEBT, BAD DEBT: DON’T GET CAUGHT ON THE WRONG SIDE OF THE DEAL

It hasn’t gone away, you know - the global ‘credit crunch’. 

OK. It seems to be taking a breather, thanks mainly to sovereign wealth funds and central banks stepping in to bail out the investment banks that were most seriously exposed to US sub-prime debt.  

But the smooth lending between banks hasn’t yet been restored and there’s some way to go before they all ‘fess up to how much they owe each other and how they still need to write off. 

Meanwhile, back here on planet Ireland Inc., a positive spin has been put on last month’s ECB decision to keep their base interest rate at 4%; this signals that there will be no rate increase this year say the optimists.  

This is some consolation, but not much, to anyone still trying to pay off a €300,000 negative equity mortgage, not to mention the fuel, food, transport, health insurance and myriad of other day-to-day expenses that are still going up. 

Credit crunch or no credit crunch, life goes on.  Lots of us are still planning to buy new homes (or at least an extra bathroom or upgraded kitchen), cars, furniture and holidays. And some of us have no choice but to replace the banger with another banger or fix the clapped out central heating system.  

Anyone looking for credit this year should be prepared to come under a little more scrutiny, so let’s keep the positive spin going:  this is an opportunity to reflect on the true cost of debt, an unfashionable notion during the boom years when it wasn’t so much a matter of how to raise a loan, but how much of a loan to raise.  

I mean, who cared how much that €300K mortgage or €40K car loan really cost when the house was rising in tandem with your annual salary and that SUV with the bull bar was… well, it was just soooo cool. 

Now that the free bar is closed, the empties are being recycled and everyone’s sobering up, it is time to revisit the concept of ‘good debt’ versus ‘bad debt’. 

For example, good debt is the kind you use to pay for third level training or education because you can expect to eventually be rewarded with a higher income. 

Good debt buys you the home that not only provides shelter, but, historically, an annual value hedge against inflation. Given enough time, it can also produce a decent capital return.

Bad debt, meanwhile, buys liabilities:  expensive, depreciating cars, holidays, furniture, electronics, clothing, etc. These short-term purchases often end up with very long-term interest bills, especially if generated by the most expensive kind of revolving debt – credit cards. 

‘A bad loan is a bad loan is a bad loan’, Gertrude Stein would have said, if she was in the credit-seeking market today.  So for debt that smells of roses instead, consider the following: 

Only borrow what you need at the most competitive rate. A €300,000 mortgage repaid over 35 years at 5.24% interest will ultimately cost you €20,000 more than the same loan at 5%.

Always ask for total repayment costs – in writing.

Headline interest rates are… just that. Only a minority of borrowers will be offered that rate, this is because either your credit rating or the amount you are borrowing is insufficient. If your bank doesn’t automatically disclose the true cost of borrowing upfront (as RaboDirect does with its revolving ‘Credit Account’) you could end up with a nasty last minute surprise. Ask to see all borrowing rates and terms and conditions before you make a decision.

Aim to keep your loan repayment period as short as possible. The effect of compound interest, especially on a long mortgage or endless credit card debt can have a devastating effect on your long-term wealth. On-line banking can help you keep track of loan repayments.

If you haven’t already done so, switch to a 0%, low cost (ie under 10% interest) credit  offer that gives you between five to nine months to reduce your balance. Pay off your credit card balance by monthly direct debit and avoid paying any interest at all. 

Ask about fees and charges that apply to fixed rate loans. 

Be careful about balloon-end car loan payments.  They are seldom more competitive than a conventional loan. 

Beware sub-prime loan offers, or brokers who sell these products.  These toxic loans are only for people who are confident of quickly repairing their credit record so that they can avail again of conventional rate loans. 

Don’t bother with expensive payment protection insurance.  It is poor value compared to PHI or a serious illness policy that should meet repayments if you fall ill or disabled.  Savings will get you over a short-term income loss.  If the worst happens, you can sell the house and the car.