Debt and personal finance

Debt and personal finance

Benel P. Lagua

In the corporate setting, there is a running debate about what constitutes the optimal mix of debt and equity in considering the capital structure of the firm.

It all starts with a realization that there are basic advantages to debt, primarily its interest being tax deductible thereby lowering the effective cost of borrowing. Then there are other reasons like debt holders having fixed return and no share in profits as well as debt holders having no voting rights thus preempting the issue of control. There are disadvantages as well: The risk of bankruptcy with rising debt obligations and the higher interest that goes with higher debt ratios.

Accordingly, the challenge in corporations is looking at the right mix. Theoretically as long as the corporation's basic earning power (EBIT/assets) is greater than the cost of debt, additional borrowing benefits shareholders. Leverage (or additional debt) can raise the company's expected return on equity (ROE).

Now, does the same argument hold for personal and family finance? One of the functional benefit of debt is it allows us to enjoy consumption today based on what we still have to earn in the future. This is indeed a very powerful concept as it increases utility to the beneficiary. Nonetheless, the individual must be careful that it is handled well and that the utility function aimed for are confined to basic items like a house and education. Beyond that, debt can be harmful to the individual and family's health.

Review the advantages of debt for corporates versus the individuals. Are interests on debt deductible for the individual taxpayer? The answer being a big no, debt interest payments are the net costs to the borrower. And since the individual does not have the same bargaining power of the corporation, the costs are generally higher. Finally, since personal debt is usually incurred for non-earning stuff or pure consumption, the concept of raising ROE becomes inoperative.

Consider the most common source of personal debt, the credit card. My friends in the industry will be not happy but, in truth, the average consumer cannot trust the quoted interest rates being advertised by our friendly neighborhood credit card firm. The astute consumer who knows his mathematics of finance will realize that the effective interest rate using actual cash flows for paying credit card debts are on the high side.

And this does not even include fees for maintaining the credit card and other penalties like being over the credit limit, late payment, etc. The regular customer also doesn't realize that when credit card amortizations are settled, especially for those who pay the minimum amount charged in the credit card bill, only a small portion of the payment goes to the principal (the amount actually owed). The bigger portion will pay interest charges. Under this scenario, it takes a lot longer to settle the account and in the long run the interest charges can be unsettling.

Credit cards are not necessarily bad. I hold quite a few myself. But they are tools of convenience and should not be used for incurring interest bearing debt. Always pay the full balance when due and don't just settle for the minimum payment required.

As individuals choose debt beyond the basics, they are making themselves prisoners of their own trappings. When we borrow, and yes, even if we technically borrow within our means, we lose a lot of flexibility to decide our fate. How many debt burdened individuals have found themselves working in jobs they don't like, for bosses they don't appreciate, and in careers that do not promise self-fulfillment only because they cannot afford to quit. They are unable to set new financial goals and objectives for themselves and their families because future income is already committed.

Individuals and families should realize that there is a debt trap that can stifle their future. Start paying more than the minimum on credit card and other obligations. Move some of your savings (which pay so very low interest) to settle some of your debt. Look at the difference in the effective interest you earn on your savings (after tax) and the effective interest of your debt. Develop a debt reduction plan and free yourself of its bondage.

The silent savings killer

The silent savings killer

from pinoysmartsavers.com

The smart Pinoy saver should be aware that there is something out there that's slowly but constantly eating up the value of their savings. This silent savings killer is inflation. You could be the best "saver" in the planet but if you do not counteract the effects of inflation on your savings you will be frustrated to find out that you haven't saved enough.

The cost of 1 kilo of rice or chicken does not remain steady. It's always changing. It can go up or it can down although that hardly ever happens. Inflation measures how much prices of goods & services have increased in a year and is expressed as a percentage. The bigger the percentage, the higher the increase in prices. Deflation, which reflects a decrease in prices, is also possible but rare.

An annual inflation of 5% means that a sack of rice which cost P1,000 last year is now worth P1,050. If this inflation rate continues, the same sack of rice will cost P1,710 ten years later and your P1,000 can only manage to buy about 29 kilos of rice instead of one sack. The net effect of inflation is that the same amount of money will buy you less amount of goods and services in the future.

When you build funds for your future needs you have to take into consideration the effects of inflation on the value or purchasing power of your money. If today you are spending P10,000 for your monthly expenses, you will need much more than that 30 or 40 years from now to buy the same amount of stuff you are presently buying. The table below shows the equivalent of P10,000 at various times in the future if the average annual inflation rate is 5%.

Thirty years from now you will need more than P43,000 to cover your monthly expenses and a great deal more in forty years. You might think that a million pesos in retirement funds is already something. But at the given inflation rate above, P1 million forty years from now is actually only worth P142,000 in today's money. So think again. If you were to retire today how long will P142,000 sustain you?

Inflation also plays a key role in selecting the right savings or investment products. You should only put your hard-earned money in savings & investments with interest rates higher than the average inflation rate. If you put it in something that earns at lower rate, your money may be growing but it will actually be losing value & purchasing power.

A regular savings account in a commercial bank typically pays 1% interest per year. If you have a P1,000 deposit in the bank it will only earn P10 in interest (forget the withholding tax for now so you won't get so depressed about regular savings account). After a year, your money has grown to an "amazing" P1,010. But wait, the cost of one sack of rice has increased from P1,000 to P1,050. A year ago, you could buy a sack of rice with P1,000 but now the money you deposited which has grown to P1,010 can't pay for the whole thing; you're short by P40. Yes, your money may have increased a bit but it can buy less.

So make sure that you put your money in an account whose interest rate outpaces inflation like long-term time deposit accounts or an investment vehicle with a great potential to grow more than the inflation rate like mutual funds and stocks. Use low-interest regular savings account only for money you use for recurring monthly expenses and your emergency fund

The world's greatest invention

The world's greatest invention

(from Alvin Tabanag)

The genius Albert Einstein, who was named by Time magazine as the “Man of the 20th Century,” was believed to have called it “the greatest invention of mankind” and “the most powerful force in the universe.” You would think he was talking about a spaceship that could take man to another galaxy or Superman come to life. He was actually referring to “compound interest.” Whether Einstein really made those remarks or not is not important because compound interest is indeed a powerful force when it comes to savings and building wealth.

Many people do not understand or underestimate the enormous power of compound interests. This lack of understanding of its value in wealth building is one of the reasons why people are impatient and not motivated to save. Compound interest can be defined simply as “interest earned on interest.” To see how compounding works, try to solve the word problem below.

You have an investment of P100,000 that earns 10% interest per year.
How much money will you have at the end of 10 years?

Those who are not familiar with compound interests will probably compute it this way:

P200,000 would be the correct answer if you use ‘simple interest’ in the computation. But thanks to compounding your money will actually be P259,374 after 10 years. The total interest earned is P159,374 instead of just P100,000. This is because the interest earned each year will also earn interest in the succeeding years. Hindi lang ang original amount na P100,000 ang tumutubo sa mga sumusunod na taon kundi pati yung kinita na interest.

The table below shows how the original P100,000 principal grows each year if you do not withdraw the interest. Notice that the interest earned every year is increasing and not fixed at P10,000. Ito ay dahil dumadagdag ang interest sa prinsipal taun-taon at sa lumalaking prinsipal kinukuha ang 10% interest, hindi sa P100,000.

Why should compounding be of interest to you? Because it makes your money grow faster. The difference in growth after 10 years may not seem very significant. However, if you let compounding work its magic for a longer time, the difference will be very big.

Look at the chart below which shows the growth of P100,000 using simple interest and compound interest. In the first 10 years the difference is not that significant based on the columns. However, starting on the 15th year the disparity is becoming more evident. By the 40th year, the difference is staggering: P4.5M against P500T.

Accumulating a sufficient amount of funds to ensure your financial stability takes time. Sa simula medyo mabagal ang paglaki ng iyong ipon, pero kalaunan makikita mo na pabilis ng pabilis ang paglaki nito. So, start saving early. The earlier you begin, the more time compounding can make you more money. Every moment you delay, you lose the opportunity to earn more. As the old saying goes, “time is money;” and as you have seen, with compound interest, its lots of money.