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Thursday, 21 November 2013

Some international consumer debt data points - part 3a in Corrosive Debt series

In this week's British press, one article about spiralling consumer debt in the UK, another about similar happenings in Russia.

Personal debt in the UK now stands at £1.4 trillion (with a T).  That's about $2 trillion.  A report by the Centre of Social Justice (CSJ), called 'Maxed Out:  Serious Personal Debt in Britain', reports the following:

  • The average household debt stands at £54k, almost twice of what it was a decade ago
  • Households owed the equivalent of 94% of the UK's economic output last year (!!)
  • Thankfully (my words, not CSJ's), a vast majority of this debt is in the form of mortgages (see Part 3 of my Corrosive Debt series - this should be consider "good" debt)
  • However, is it really "good" debt?  Unlike many other countries, British mortgages are typically based on floating interest rates.  The UK government is concerned that when record low rates (currently 0.5%) start to rise, many of these 'good' mortgages will become unaffordable.
  • According to CSJ, nearly 4 million families do not have enough savings to cover their rent or mortgage for even one month.  
  • Looking at non-mortgage consumer debt, the amount outstanding is £158 billion (so an average of £3k per citizen).  This will mostly be 'bad debt'.  Credit card debt represents about £58 billion (£1k per citizen) - a lot of the remainder are 'pay day' loans (loans to help folks reach their monthly payday) and similar.  As a comparison, The US average household has $14k of credit card debt.  So Britain, with 26 million households, is slightly better off than their US counterparts with a little over $3k in credit card debt.
  • Unlike the US, where people have been paying down debt in this low interest rate environment, people in Britain don't seem to be taking advantage of the same opportunity.  
The full CSJ report can be found here.   

Switching gears to Russia, yesterday's Financial Times reported various Russian central bank warnings regarding 'high household indebtedness'.  Some snippets:
  • The central bank head states 'there are already visible elements of overheating'.  She notes 'exceptionally high level" of households' debt and is concerned on its impact on financial stability.
  • Russia's largest bank is now warning of a consumer credit bubble in 2014.

You may be asking yourself what is the relevance of these stories to the New Investor?  Well, as I have stated emphatically before, you cannot prudently start a long term investment program if you are mired in bad debt.  If you are one of those with high personal debts, make a plan to start paying yourself first NOW and use this 'new-found' money to get out of debt asap.  Because interest rates WILL go up.  It is a mathematically certainty.  

And when interest rates do rise, if you have crushing, floating rate debt, not only won't you be a successful investor, you'll be fighting for financial survival.  See the difference?

Wednesday, 6 November 2013

The corrosiveness of debt – part 3 (when to use debt & when not to)

It’s like we’ve all been in a collective deep slumber…lasting many years. 

We, as a society, have enabled, through our inaction, a new addiction to form.  Whereas some take an ostrich approach and willfully ignore the new dependence, others are lured into the attractiveness of the offering…like druggies to crack or heroin.  Still others are just plain ignorant and yet many more believe the polished & targeted marketing crammed down their throats.  To what do I refer?  Debt.  Insidious, destructive debt.

I’ve intimated it in my prior corrosiveness of debt posts but now I’ll be more explicit - debt is an effective way for others to enslave you.  Please pause, take a deep-breath and re-read that last sentence again (and again).  Because unless & until you fully understand what instruments are being actively used against you - to control you - what hope do you have? 

We’re all very familiar with the mortgage-led housing crisis of recent years.  Most of the problems stemmed from dishonest brokers & bankers coupled with foolish borrowers and stupid investors (among others).  But as I describe below, real estate is one of those assets where, ironically, it makes sense to use debt.  Just use common sense, know that you can pay the mortgage each & every month, and take the time to understand the particulars of your mortgage offer. 

But more broadly speaking, using debt to live beyond one’s means is insanity.  As Albert Einstein so famously said, insanity is doing the same thing over and over again and expecting different results.  If you feel that you never have any money to invest, yet you’re making ends meet by using debt, don’t expect this to change.  Ever.  You have been brainwashed to believe you need that new product or service and are willing to mortgage your future to get it.  In short, you have lost your capacity to think, and to act, in your own best interest.  Now how does that make you feel?

Pigeons unite!  (or not...)
We have a family joke that whenever one of us is manipulated by a third-party or perhaps acts without thinking, we’re acting like a pigeon.  In fact, to make the joke even funnier, we refer to the guilty party as a pigeon detective.  With rich irony, of course.  Can you imagine a pigeon using logic to analyze available facts to determine best course of action?  No, I thought not.  And that’s precisely the point I’m trying to make:  no one aspires to be a pigeon (at least I hope not!).  Societal pressures may try to dumb us down to spur us into making that spontaneous purchase; but we must fight back by remaining vigilantly open-minded, always seek the truth, and being prepared to defend ourselves against nefarious actors.  The same characteristics apply to the astute young and/or novice investor.

Real vs. not so real…
Fact:  debt can be a useful tool, enabling both individuals & companies to purchase things that they otherwise could not purchase.  But let’s be crystal clear here - purchasing anything other than real assets with debt is a sure-fired way to find oneself firmly on the path to financial destruction.  My goal at newinvestortoolkit is to help young and novice investors get on the road to financial freedom, not financial ruin.  Consequently, to achieve this goal, I need to share with you pitfalls to avoid; some of which I have experienced personally over the last 20 years.  That is why I’m focusing so much attention in my initial NITK blog posts to the corrosiveness of debt theme.

Real assets - when debt makes sense
So when does debt make sense?  Real estate.

Given global population growth projections, the demand for quality housing will always be greater in the future than it is today.  There are, our course, obvious exceptions to my gigantic generalization (both by country & by region & by city).  Where my generalization is completely accurate, guaranteed 110%, is in cities like London and New York.  Simple supply & demand, my dear Watson.  A lot of people want to live and/or invest there (demand) and there simply isn’t enough new properties being built (supply) to match the demand.  Other cities may offer similar ‘slam-dunk’ return potential but probably not as assured.  Austin, Texas, for example?  Not a given but probably still a good bet.  What about Detroit?  Speculative, at best.  You can make a killing…but also may loss your entire investment.  As you’ve no-doubt heard many times prior, choose investment property locations prudently. 

But based on empirical evidence, one can assume that over the long-term, house prices (including apartments/flats) will increase over time, usually in excess of inflation.  That, coupled with the relatively low cost of the mortgage (because the loan is secured against the property), makes real estate a solid long-term investment.  And in this specific circumstance, debt provides good value to you, enabling you to buy a real, appreciating asset with much, much less costly debt than the average credit card charges (two main reasons for this: (1) credit card debt is unsecured, unlike a mortgage, and (2) almost anyone can get a credit card these days with no need for ‘equity’.  Yes, mortgages were given to individuals with no equity and the standards for approval were lax, running up to 2008…and we saw where that got us.  I assume the mortgage industry will continue to adjust its eligibility criteria back to historic norms).

Another great example of the usefulness of debt, at least as it pertains to the corporate sector, is in acquiring cash-producing companies.  The benefits are multiple:  (i) you get a tax break for use of debt; (ii) debt increases equity returns of the corporate, albeit by increasing financial risk to its shareholders, (iii) you can use the acquired company to pay a portion or all (and more) of the debt borrowed for the acquisition.  Suffice to say in this post that corporate debt, when used properly, is an excellent tool for management to create shareholder value.

Soft assets – when to avoid debt like the plague
So if we understand what real assets are, how to describe all non-real assets?  Generally speaking, non-real assets (also called ‘soft’ assets) are those that lose value over time - e.g., flat-screen TVs, PCs, iSomething, clothing, food, vacations, etc.  The strict rule to follow is that soft assets should never be purchased using debt.  Ever.  Let me repeat:  for your own financial well-being, do not ever buy a soft asset with debt.  (There may be one exception – automobiles.  Whereas I believe cars are soft assets - we’ve all heard new cars lose 25% of their value once driven off the lot - if you need one to get to work and don’t have the money to buy one outright, then I think it rationale & necessary to use debt to acquire one.  But use the ‘pay yourself first’ technique found in the prior blog post to pay off the car loan as quickly as you can). 

Many people use credit cards to fund more than useful “float”.   Remember my credit card experience when I was a young man living in New York (described it in my credit card post)?  Suffice to say here that such a purchase is a bad trade for you.  Why?  You end of paying 10-14+% interest charge on the money used to purchase an asset that becomes worth less and less over time (in the case of technology, a product value’s “half life” can even be measured in months, not years!).  I’ve known folks who still carry credit card balances for items they no longer even own.  You must avoid this at all costs.  Defer that urge for instant gratification.  Avoid that spontaneous desire to consume, consume, consume!

Sad fact:  we’ve been programmed to consume (beyond our means)
The rather unpleasant reality is that we’ve been programmed to always buy the latest gadget or to upgrade or even to have multiple devices that essentially do the same thing.  And since, perhaps, the 1990s, a lot of us in the West have been living beyond our means….and funding the gap with cheap debt. 

I’ve heard our society’s materialistic-centric model described – perhaps exceedingly harshly & cynically (but sometimes that’s needed to wake us up from our slumber) – as follows:  The average citizen’s utility to the powers that be is to produce, to consume and then to die.  Money has, in many ways, become the end game in itself, not a tool by which to just play the game.  

The fact is, you need to be smarter than others with respect to debt.  And you need to start being smarter NOW.  Make your own rules for how you use debt…and how not to use it.  Two summarizing tips:
  • Never use debt of any kind to purchase ‘soft’ assets
  • Use credit cards judiciously: (i) aim to never carry a credit card balance into the next billing cycle and (ii) only use credit card debt as ‘float’ (see my blog on credit cards if you don’t understand this point).
To summarize, use of debt to purchase hard assets can be an excellent use and you can do very well indeed on your ‘equity’ portion of the transactionBut don’t use debt (in particular, high-cost credit cards) for buying soft assets.

Next debt bubble, coming up…
Which brings me to what many consider to be the latest debt bubble (at least in the US) and one of the main reasons why I stated in the opening paragraph that we’ve all been asleep at the wheel.  It’s been a growing problem since I went to college (way back in 1985 to 1990…yes, I was on the 5 year plan:)) and only recently has it entered into our public discourse.  Namely, the growing problem of student loans.

Student loans are crippling our young generation (i.e., the young investor, thus my personal interest), financially, psychologically and morally.  I’ll tackle this in my next blog post.