Debt is a financial force multiplier of your judgement. With this instrument you can have either what is called good or bad debt. Good debt is the financing of hard or income generating assets, where ideally the capital appreciation and/or the income from the asset is sufficient to cover the interest payment(s). Bad debt is consumption with money that is not yours that you have to pay back eventually.
The judgement to be in bad debt is governed by the extent to which you require instant gratification or in other cases the extent of the emergency you are faced with. Whereas the judgement to be in good debt is governed by your risk appetite as well as aspirations to either retain or build wealth.
Overall, the decision to be in either form of debt is determined primarily by how much you value your future to the demands and desires of the present. Economists call these time preferences. Thus, if you live for the moment at the cost of the future you have short time preferences, in other words, you’re short sighted. However, if you value sacrifice you have long time preferences.
How and why so many households get into a bad debt spiral
Over 75% of the take home-pay for most South African households goes to paying off debt. Since 2016, unsecured lending (credit cards, personal loans, access facilities) has increased 26%, and unsecured lending predominantly goes towards consumption (Joseph Phiri, 2021).
There are 3 noteworthy reasons for the rise in bad debt. The first is the incentive given by the monetary system to have a good credit score and to have a good credit score one needs a credit history and the low hanging fruits for credit products include retail store accounts, credit cards, personal loans. The second is keeping up with the Jones, where people buy things they do not need with money they do not have to impress the people they do not like. The third is the rising cost of living, also known as inflation. Since 2016 the cost of living has risen by 40,11% as measured by the consumer price index (CPI). However, this measure underestimates the extent of consumer suffering as they experience a fall in their purchasing power.
There are two noteworthy reasons why the CPI underestimates the fall in consumers’ purchasing power. First, the CPI does not factor in a few key necessities such as the cost of having a home even though it is meant to be a measure of the rising cost of living. Second, the cost of owning a Toyota Corolla in South Africa has become dramatically more expensive. Over the past 20 years the CPI has increased by 175% (average annual increase of 5.5% per year) whereas the cost of owning a Toyota Corolla has increased 427%. The car in 2023 has breached the half-a-million-rand mark. Thus, as the cost exceeds the budget for a significant proportion of motorists, much cheaper entry level cars with poorer safety, reliability and quality become the norm. When motorists make this shift to a lower standard of living the CPI does not take this into account, leading some Economists to argue that the measure has what is called a "substitution bias".
Lack of Leverage
Around one out of every six people that have the opportunity to earn a living in South Africa own a business, the rest are dependent on a wage or salary. This means that for a great proportion of South Africans the leverage they have is based on the scarcity of their skills, their ability to negotiate, to unionise, among other labour market factors. These factors affect the proportion of income given to employees for work done and is also known as the labour share.
The South African Average Monthly Gross Wage (SAMGW) has grown in lockstep with the CPI; for instance, over the past 10 years the SAMGW has grown by 67% and the CPI by 64%. Thus, with salary increments dependent on a faulty metric such as the CPI, the income for most workers falls behind the rising of cost of living. Debt becomes the financial force multiplier to satisfy the gap. Those with a longer-term view may gravitate towards entrepreneurship to supplement the income necessary to at the bare minimum remain commensurate with the standard of living they have.
The relationship the rich have with debt
“Never use your own money” is a law that is preached and practiced by many wealthy individuals. Favourable credit allocation in the form of lower interest rates and longer-term structures is given to those with a higher net worth and/or high level of income. This gives them opportunity to create a cyclical cashflow structure.
Robert Kiyosaki illustrates this point with the use of a balance sheet and an income statement. Say the bank grants you a million rand of revolving credit at a low interest rate of 8% (prime minus 2.75% at the time of this writing.) You purchase an R800 000 apartment and use R200 000 to refurbish the place. Now the apartment has a market value of R1.2 million; you then rent it out at R14 000 per month which is sufficient to cover the monthly interest payments you have to pay of approximately R8500 and the maintenance, utility, as well as the rates and taxes for a combined monthly fee of R2500. The net rental income in this scenario is the free cash flow you have of R3000 per month. Which is all illustrated in the table below.
As the price of the apartment appreciates in the market, you can take a collateralised loan against the apartment, which you own as an asset. With at least another million rand you can repeat the process to build up your property portfolio, all without having to use your own money. However, this example is not exhaustive of the strategies deployed to generate income from assets that are purchased with debt.
Most households fall behind the rising cost of living due to a lack of leverage. Labour is the only form of leverage available to most households and since on average salaries and wages rise with the CPI their purchasing power falls in real terms. Debt is a form of leverage available to everyone that is deemed credit worthy by financial institutions and can be a tool for financial freedom or slavery depending on how it is utilised.
As Albert Einstein put it:
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't pays it.”