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.