Get Out of the Debt Danger Zone

It was one of the things I hated about living in Europe. It was always hard to find a car park. As if the great discovery of the modern age — the automobile and the freedom of the open road — had been somehow lost amidst tightly packed towns.

So you end up parking afar. And walking. Which seems a nice idea, except on the many days when rain comes horizontal with the sharp bite of the Northern cold.

One of the walks I used to do was through the town park and into the high street.

Sometimes, when the weather allowed, I’d stop to let the children play on the equipment. Then I’d feel nostalgia for New Zealand, where the children’s playgrounds are not filled with cigarette butts. Or frequented by drunks.

Like much in life, you can create something beautiful. Or watch it get destroyed. It appeared to me that at the town park, people simply didn’t care.

One of the most fascinating speeches at my local Toastmasters group recently was from a guy who works at a charity helping people deal with debt.

Christians Against Poverty — or CAP as they’re known — refuse to sit back and watch lives get destroyed by one financial force that is too often overlooked in our economy.

Easy debt.

People become ready victims, he warns. It starts with something simple. Not having enough money for a winter electricity bill. You’re afraid the power is going to get cut off and the children are going to get cold and sick.

In your community, a loan shark is offering easy cash. You take it to pay the power bill. Not realising that some of these loans comes with rates in the hundreds of percent.

Then admin fees get slapped on top. And very quickly, your financial life becomes a mess. And the more debt you take on, the harder it is to clean it up.

Interest on money has been illegal at various times throughout history…

Past societies have acknowledged the risk of debt and interest. Interest of any kind is forbidden in Islam. In the Hebrew Bible, interest could be charged to strangers but not between Jews. In Europe, this tended to create a concentration of Jews lending money to non-Jews.

In 13th century England, a ‘Statute of Jewry’ was passed which made usury (the charging of interest) illegal and allowed assets of the violators to be seized. This anti-Semitic law, of course, specifically targeted Jewish moneylenders.

The trouble with interest is that it is a charge, but no product is rendered in return. It is the price of money.

Yet, over time, usury was freed up as demand from commerce and trade increased. And in that context, interest made sense — borrowing money where it could be applied to yield a profit over and above the interest charged.

Today, interest is used again by large banking companies and wealthy groups to profit. And it has become a dangerous fundamental in our modern economy.

Here in New Zealand, our housing market is built on access to debt. We recently reached an all-time high where our household debt-to-GDP ratio sits at 94% — among the highest in the OECD.

This debt is only productive if the value of those houses increases. Or the rental yield on them exceeds the interest cost.

Because modern economies are now so debt-based, the government — via the Reserve Bank here in NZ — uses the ‘base rate’ or OCR (Official Cash Rate) to ‘influence’ the economy.

Lower it and, in theory, that should encourage people to borrow, invest and get the economy growing.

Again, debt is not well-understood. Its misuse creates dangerous asset bubbles. Most households use debt to consume. Unless your home delivers a return above the cost of your debt — it is not a very productive asset.

Well, not to worry, the OCR is now at a record low of 1% after being cut 50 basis points

But…this makes me even more worried.

Studies in the US economy show that cuts of up to 4% are needed to successfully pull the country out of recession.

So you need large and sustained cuts to make a material difference.

With the OCR at such a low level, there isn’t any room left for much further stimulus should our economy fall into recession. And New Zealand has a narrower economic base than the large US economy.

  • What happens if demand for our exports turn off as China slows down?
  • What happens as we pull back on unsustainable migration?
  • What happens when house price deflation throws many mortgages into red-flag territory?

You enter serious crunch territory. The value of assets like property and stocks fall through the floor. It’s like the Global Financial Crisis all over again — but this time there’s no room left to cut interest rates.

Clean up the playground

Debt magnifies financial risk.

To protect the most vulnerable, maximum interest rates ought to be more protective. In Canada, interest rates are limited to 60% per year. And anti-poverty groups are calling for that to be reduced to 30%.

Here in New Zealand, measures are due to come into effect from 2020 that will limit interest and fees on high-cost loans to 100%.

But is it enough?

What borrowers can do is constantly review their debt and get educated. Asking the key question, ‘Can I actually make a profit on the interest I’m being charged? Can I do it either through yield or capital gain?

If the answer is no — well, you have bad debt, not good debt.

The problem we have in NZ is that housing shortages and costs have magnified bad debt for many first-home buyers.

Take a mortgage of $500,000 at the average current floating rate of 5.78% over 25 years. You’ll end up paying back $946,381.

So that debt costs you $446,381 — or about $37,200 per year.

The question to ask is this: ‘Will this drawing down of debt allow me to make up at least $37,200 each year?

In a fast-growing property market, that can be justified. But when you’re looking at falling prices, it’s much more difficult.

And if prices are still falling in a low interest-rate environment, it’s hard to find much hope for further price stimulus.

Sometimes the ideal situation is to buy a property that can also generate yield. For example, it has a rentable area available. Or you’re willing to take in flatmates.

But, again, have you considered the rent money you may save? Or the extra cost of home ownership?

Above all, a good financial question to ask is, ‘How can I get a return on this debt — and use it as a weapon for me rather than against me?

It comes down to maximising the return on every financial decision you make.

That’s something we look at in detail in our Lifetime Wealth Investor premium newsletter. There, we provide specific analysis of best capital growth and yield options we can find in the global markets. Join us there for more.

Regards,

Simon Angelo

Editor, WealthMorning.com


Simon is the editor of Wealth Morning and has been investing in the markets since he was 17. He recently spent a couple of years working in the hedge fund industry in Europe. Before this he owned an award-winning professional services business and online learning company in Auckland for 20 years. He has completed the Certificate in Discretionary Investment Management from the Personal Finance Society (UK), has written a bestselling book and manages global share portfolios.


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