Factors to consider before taking a loan
By Elizabeth Nkukuu
A lot has been said about debt and some of us have some bad stories when it comes to it. The main question then becomes is the debt all that bad and what is debt anyway. In the simplest form debt is the money borrowed by one party from another to serve a financial need that otherwise cannot be met outrightly.
The important thing to note is that there must be a specific financial need that you intend to achieve. The need should be in most situationsFac investment based for it to make sense. Consumption debt should be avoided as it derails our financial freedom journey by getting things we might not necessarily need.
There are two broad categories of debt that is; i) Good debt and ii) Bad debt. The classification is based on what the funds borrowed are used for. If one has borrowed money for a good investment then that is good debt but if debt is largely for consumables, then that is a bad debt.
There is no clear cut on what consumables can be because in as much as we are advised against taking loans for something like vehicles if they are a necessity for our jobs, then they are not bad debt after all. One should ensure that the returns to be derived from the investment being undertaken are way higher than the cost of debt.
One need to be careful in identifying the need they are borrowing for. There are situations whereby a debt starts o as a good debt I.e debt for investment and then it ends up being bad debt as the business we undertook stops performing.
For entrepreneurs, debt can help them grow their businesses much faster if they have already validated their business concept and are already generating revenues. The key thing is that we should try as much as possible not to borrow money to start a business since if we do not understand the business, we might end up losing the invested capital and remain with a debt that we are servicing. We should only borrow to scale up businesses that we know are doing well.
The other key advantage of using debt as a business owner is the fact that the interest cost is tax allowable, reducing the overall tax payable by the business. When taking debt there are a couple of things that we need to look at:
i. Review your financial goals: See whether this loan helps to get you closer or further from your goals. If the debt is not in furtherance of your goals, one should not take it as it will derail your financial journey;
ii. Review various providers: One can get debt from various institutions from formal ones like banks, Saccos, Microfinance, Shylock, digital lenders among others. One needs to know the pros and cons of borrowing from these institutions and select the one that fits their specific need.
iii. The cost of debt: One should ensure that the returns to be derived from the investment being undertaken are way higher than the cost of debt. One should aim to negotiate the lowest interest costs and also negotiate down the other costs.
iv. The time horizon: Depending on what the funds are to be used for one should aim to match the investment cashflows with the debt repayment cashflows. If one is taking money to undertake huge capital expenditures then what makes sense should be to take a long-term loan.
v. The other specific terms of the contract. One should consider including insurance as this helps one sleep easier as they work on the loan. When you have taken debt and you find yourself in a bad debt situation, a place where you are now struggling to pay o the debt either because the investment is not well performing or because you have lost your constant flow of income one should do two things:
i) Stop and ensure the situation is arrested by not digging deeper into the debt hole. Do not borrow more no matter how dire the situation is.
ii) Look at ways to restructure the debts so that they can be quickly turned around. We saw a couple of businesses and an individual benefit from this as the Central Bank of Kenya allowed banks to consider and do the loan restructuring. The worst position to be at when you find yourself in a bad debt situation is to
despair and give up hope. If you are in business there are legal remedies that one can invoke to give the businesses time to review and turn around e.g voluntary administration.
If you are an individual, having a conversation with your bankers would give you some insights on possible debt consolidation recommendations that would help relieve some pain All in all, we should learn how we can use debt for our own growth as individuals and businesses.
The timing of when we need to take the debt and how we shall repay the debt should be clear and that is why we should work on a clear sensitivity analysis of the investments we are to undertake so that we are sure that returns are above the cost of debt and the cashflows are sufficient.
To avoid getting into debt problems also ensure you are clear about how you are lending money and who you guarantee, in cases where you have to, as that could be an additional burden you are taking over.
Just like other important matters in life such as health, career etc, finances and debt management could need more individualised conversations and so never feel the shame of seeking help, it frees you and you get some new perspectives that will help you get out and forge ahead.
–The writer is a personal finance expert.
