Have you ever been in the middle of a movie and then had to step out for one reason or the other? Maybe it was to take a phone call, make a snack or finish a chore. When you get back to the movie, you find you’ve lost track of the storyline and hence spend the remaining time playing catch up. You start irritating others who were watching the movie by asking what happened, when did so and so appear, who is this among many other annoying questions. Well this week we tackled debt in our class and what intrigues me about this topic is the different aspects that keep coming out depending on one’s approach and situation. I spoke to someone who said she feels like she is playing catch up with her debt, hence the theme of this article. Like in the movies, her life got interrupted by a certain loan and she is trying to catch up to a place where she can actually afford to have the loan or even go back to living life before the loan. Like many people, she did not really understand the implications of that loan and maybe you can relate to that. You took out a loan or a series of loans and you now wish you never had. You thought you could handle it, it looked good on paper, but now you realise you couldn’t afford it. Let’s look at some of the things that put us in this situation through the story of Susan.
Susan took out a car loan for two million shillings. The bank did their own ratios and concluded that she could afford the loan. For your information banks will look at your income and ensure that your monthly repayment does not exceed a certain percentage. Therefore, depending on the bank’s policy they may lend you an amount where the repayment doesn’t exceed thirty, forty or even sixty percent of your income. It is referred to as a Debt to Income Ratio. Susan’s car repayment ended up being fifty percent of her income. Remember the bank is making money by lending to you. The fact that you may struggle with other things because of repaying this loan is not their problem.
Susan is one of the people who have struggled with this. She now realizes that to comfortably afford the loan, she needs to be earning thirty percent more than what she is earning. She needs her income to increase just to afford a loan that she has already taken. This increase is to simply catch up with the loan. Aside from having the car, this is what will put her back into being able to pay her bills on time and save, just like she used to before taking the loan. Can you see the irony in that? This increase that should ideally work for her financially through increased savings and investment, will only serve to put her right back where she was. She will work hard to earn it but because of this it will never quite feel like the increase it is. She will actually be working for the car. In case you are wondering, I told Susan to sell her car, pay off the debt and get a less expensive one. People are playing the same sort of catch up in different ways. Through credit cards we are stuck paying up for clothes, gadgets and other items we should never have bought in the first place. The holiday season is coming up. People are known for taking loans to go on holiday and then spending a full year paying it off or catching up for it.
Let’s assume she doesn’t sell it. Many people after all do hang onto things they can’t actually afford. They don’t want to risk their image. Assuming the loan period is five years, she will end up paying another extra one million shillings because of the interest. When we are thinking and only dealing with the here and now, we may not even realise the impact of our actions in the future. We do work with people who are about to retire, who get to realise what the opportunity cost of some of these actions are. Let’s leave the cost of the car aside and deal with the interest. If Susan invested that one million shilling, in twenty years it will be worth ten million shillings, on a basic investment. This increase is because over time the money compounds i.e. it (including returns) is continuously reinvested. When she retires, she may realise that her portfolio needed to have that ten million shillings to cater for her. This is the realisation our clients get. It is that one decision that has cost them a proper or ideal retirement fund. Now without the benefit of time, they would have to figure out how to make the same ten million shillings. However, twenty years ago, it was simply the interest on a car. This debt can possibly put Susan in a catch up situation when it comes to her own retirement or other goals in life. People have not been able to do certain investments because of debt. When they can finally do it the investment is no longer available and hence the opportunity is lost. Businesses have not been started at the right time because of this debt. Children are unable to go to certain schools or colleges because of this.
Debt like this almost seems to have the ability to freeze time. You may look good in the nice car but in reality you don’t move forward. You feel stuck. It’s even worse when we keep borrowing, one loan on top of another. You can end up playing catch up all your life. When you borrow be very clear about it. Take time to do the calculations so that you don’t end up in a catch up situation. Evaluate that loan properly based on your income but also the opportunity cost. Don’t let debt rob you.